FTSE Global Markets by FTSE Global Markets

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WAL-MART LOOKS FOR NEW WORLDS TO CONQUER ISSUE FIVE • JANUARY/FEBRUARY 2005

Special Report:

CHINA

FRR to the rescue Cemex buys into RMC Group

State Street OUTWARD

BOUND

THE RESURGENCE OF US BUYOUTS

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120 years of local presence has given us a wealth of local knowledge. When striving for local understanding, it’s important to spend quality time with your hosts. That’s when you really get to the heart of their culture, down to the words they use. Fortunately for us, we’ve had a 120-year headstart – so much so, we've become a local ourselves. It is this depth of understanding that helps us pick the best banking solutions from all over the world and tailor them to best serve local needs.

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTING EDITORS:

Karen Jones, Neil O’Hara, David Simons. SPECIAL CORRESPONDENTS:

Andrew Cavenagh, Art Detman, Stuart Fieldhouse, Rekha Menon, Tim Steele, Bill Stoneman, Angela May Ward, Paul Whitfield, Ian Williams. FTSE EDITORIAL BOARD:

Mark Makepeace [CEO], Carl Beckley, Graham Colbourne, Peter de Graaf, Paul Hoff, Marianne Huve-Allard, Stuart Ives, Paul McLean, Jerry Moskowitz, Gareth Parker, Jamie Perret, Claire Spraggett, Sandra Steel PUBLISHING & SALES DIRECTOR:

Paul Spendiff OVERSEAS REPRESENTATION:

Adil Jilla [Middle East and North Africa], Faredoon Kuka, Ronni Mystry Associates Pvt [India], Ferda Akyürek [Turkey], Harold Leddy & Associates [United States] PUBLISHED BY:

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Mailcom plc, Snowdon Drive, Winterhill, Milton Keynes MK6 1HQ FTSE Global Markets is published six times a year. No part of this publication may be reproduced or used in any form of advertising without prior permission of FTSE International Limited or Berlinguer Ltd. FTSE Global Markets is published by Berlinguer Ltd on behalf of FTSE International Limited. [Copyright © Berlinguer Ltd 2004. All rights reserved.] FTSE™ is a trade mark of the London Stock Exchange plc and the Financial Times Limited and is used by FTSE International Limited under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited for any errors or omissions or for any loss arising from use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or its licensors. Redistribution of the data comprising the FTSE Indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited or Berlinguer Ltd. ISSN: 1742-6650 Journalistic code set by the Munich Declaration.

s we cross into a new year the themes that stand out in this edition include continued market liberalisation in China and Malaysia, the return of the US buyouts market and the progress of capital market reforms in America. They have topicality, but are also issues that will continue to be writ large throughout 2005. China and Malaysia look to continue their dominance as Asia’s growth powerhouses through 2005 and continue to throw up new opportunities for investment bankers and investment managers alike. In some ways their fortunes are entwined, or at least are moving on parallel paths. Both, for example, are coming under pressure to revalue their currencies and both are lodestones for investor sentiment in the Greater Asian region. We look at the short prospects in both markets, concentrating on China in a special extended report in the Regional Review section. Private equity fund-raising was doused after the dot-com bust. However, these days buyout firms are finding strong demand for their latest offerings. The high-yield market has re-opened to leveraged financing, initial public offerings are on the rise, and a pickup in merger activity may even herald the return of corporate buyers. Neil O’Hara reports on the impact of the rebirth of the sector. The cover story this month is a profile of investment services specialist State Street Corporation. The market-making institution is in transition. In spite of an era of slower growth, the bank is locked and loaded for bear. Armed with a focused and driven chairman, an improved global infrastructure and a new outward-looking business strategy the bank is hunting for new growth outside the United States. We assess the opportunities ahead for the bank in an era of high competition in the investment services sector. The industrial sector report covers the impending acquisition of the UK’s RMC Group by Mexican cement major CEMEX and the international expansion of American retailing giant Wal-Mart. Both firms show aggressive growth trajectories and we analyse what makes them so successful in their relative fields. If you did not send in one of the questionnaires we provided in the last edition you still have the opportunity to tell us what you think about FTSE Global Markets on the www.ftse.com website. Your feedback is important to us and we would be most grateful if you could spare a few minutes to answer some simple and pertinent questions about the magazine. We will make full use of the replies and it does help us to focus on issues that are of real interest to you. We will donate £1 to UNICEF for every completed questionnaire sent to us. We also take this opportunity to wish you all a happy and prosperous 2005. Thank you for your time and attention.

ADVERTISING AND SUBSCRIPTION ENQUIRIES:

Contact Paul Spendiff EM: paul.spendiff@berlinguer.com DL: + 44 [0] 20 7074 0021 FX: + 44 [0] 20 7074 0022 Subscription Price: £399 per annum [6 issues]

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

Francesca Carnevale, Editorial Director December 2004

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Contents COVER STORY STATE STREET HUNTS FOR NEW BUSINESS ABROAD

....Page 38 Armed with a new chairman and a new business strategy State Street Bank is working to defy expectations that its dominance of the US mutual fund market cannot be repeated in Europe and Asia. State Street thinks differently. Francesca Carnevale reports from Boston on the bank’s outlook.

REGULARS MARKET LEADER

THE RISE AND RISE OF REITs ..............................................................Page 6 Karen Jones analyses key trends in the US real estate investment market.

IN THE MARKETS

THE OUTLOOK FOR CONVERTIBLES ........................................Page 10 Luke Olsen and Haidje Rüstau focus on the market drivers.

Changes to US IPO regulations....................................................................................Page 18

REGIONAL REVIEW

Regulation NMS creates upheaval in US equity markets........................................Page 22 Malaysia ups the ante ....................................................................................................Page 25 IFC leads new Islamic finance issues in Malaysia ....................................................Page 27

Chinese IPOs make a comeback ..................................................................................Page 29

SPECIAL REPORT CHINA

QDIIs wait for the green light ......................................................................................Page 32 Investors enjoy a surfeit of choice................................................................................Page 34 MPF reform......................................................................................................................Page 37

EQUITY REPORT DEBT REPORT

TRANSITION MANAGEMENT ............................................................Page 64 Is implementation shortfall an effective measure of a successful transition?

FRENCH BONDS BROADEN THEIR HORIZON ..................Page 69 Andrew Cavenagh reports on the growth of the French covered bond market.

PORTFOLIO MANAGEMENT ..............................................................Page 84 INDEX REVIEW

Why Stochastic Portfolio Theory really works Market Reports by FTSE Research ..............................................................................Page 87 Calendar ..........................................................................................................................Page 96

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

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Contents FEATURES CEMEX’S NEW BRIDGING STRATEGIES

..................................Page 43 Ian Williams tells the story of Cemex’s latest expansion efforts, in particular the impending acquisition of the UK’s RMC Group and what that means for the construction and buildings material sector.

ALL HOPES PINNED ON FRR

..............................................................Page 47 Much is expected of France’s major pension fund and of Antoine de Salins and his team. It’s a heady responsibility, but FRR believes it is up to the challenge. Paul Whitfield reports.

WAL-MART LAYS DOWN THE GAUNTLET

........................Page 51 There is no stopping of the American retail supergiant. So it seems. But other US retail majors have been quick to learn the lessons that Wal-Mart has taught them and threaten to do it better. Dave Simons reports.

MIDDLE EAST BANKS ON OIL MONEY

..................................Page 55 It is a heady time for banks in the Middle East, loaded as they are with liquidity, a growing client base and an expanding repertoire of financial services. But now foreign banks are eyeing the region with envious eyes.

THE TURNING POINT

..................................................................................Page 59 Clients are looking to consolidate the number of providers they use and embrace a more ‘one-stop shop’ asset servicing model. How will fund administrators reconcile the inexorable downward pressure on fees with clients’ demands for an increasingly sophisticated service? Tim Steele finds out.

THE FLIGHT OF THE PHOENIX

..........................................................Page 74 Initial public offerings (IPOs) are on the rise, and a pickup in merger activity may herald the return of corporate buyers. Neil A. O'Hara reports from New York that private equity is back in vogue.

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

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Market Leader

REITs have attracted increasing interest from institutional investors in the US. Will the burgeoning interest in US REITs be sustained once interest rates go up? Karen Jones reports from New York.

20 18 16 14 12 10 8 6 4 2

FTSE US Real Estate Index

FTSE US Yield

FTSE US Real Estate Yield

0-1 21

-1 03

FTSE US Index

03 1-

02 1-

01 1-1 23

00 2-1 06

-1

0 20

140 130 120 110 100 90 80 70 60 50 40 30 20 10 -1

Index Performance (Rebased)

FTSE US Index vs FTSE US REITS Index – Capital Performance and Dividend Yields

expenses and the remainder you give to your shareholders.” He defines a REIT as a company which has to have 75% of its assets as income producing properties, “which prevents General Motors and Intel from operating as a REIT.” REITs must agree to pay shareholders each year 90% or more of their income in dividends. In return the Internal Revenue Service grants a dividend-paid deduction, meaning every dollar the company pays out in dividends, it is entitled to deduct from its corporate tax liability. Companies therefore pass on the tax savings from

Dividend Yield

INCE THE MIDDLE of 1999, investors have enjoyed what is the longest bull market for REITs since Congressional legislation in the 1960s opened up the market to a broad range of investors. The market is now better understood and appreciated as an alternative high yield investment, with high levels of corporate governance practice, maintain some commentators. Others wonder how long the good times can last. Michael Grupe, senior vice president for research and investor outreach at the National Association of Real Estate Trusts (NAREIT), the Washington-based trade association representing the REIT and publicly traded real estate industry, says that in 1990, the total equity market capitalisation of US REITs was less than $10bn. Today, the industry’s equity market capitalisation is $275bn. NAREIT lists 187 publicly traded REITs in its Composite Index (154 are traded on the New York Stock Exchange) with assets totalling $400bn, or 10-15% of the total real estate market owned by institutional investors. The REIT business is “relatively simple” says Grupe. “You own the space, you rent to your tenants, you collect the rental payments, pay your

-1

MARKET LEADER

REITs continue on their roll

the dividend deduction to shareholders, making REITs an attractive investment. REITs paid out approximately $11bn in dividends in 2003. Dr. Ron Donohue, director of research at Hoyt Advisory Services, a consulting firm specialising in asset management investment analysis offers that because REITS own and lease real estate, they have different investment features than other investment classes. “If you have ever rented office space, the rates don’t change that much and they tend to follow inflation. The reality about REITs is the last few years is (sic) that prices are going up and the dividend yields have been driven down. That is not because REITS are doing great and the prospects are glowing, it is because where else are you going to get a 5-6% rate of return? You won’t see many choices (sic),”says Donohue. Darren T. Rabenou, vice president and client portfolio manager, JP Morgan Fleming’s Real Estate Securities Group, says that large institutional investors are “generally underweight”in real estate as a whole and have memories of being “burned”

Data as at 31 October 2004. Source: FTSE Group

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

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Market Leader MARKET LEADER Michael Grupe, senior vice president for research and investor outreach at the National Association of Real Estate Trusts

in the past, particularly in the early 1990s. However he is seeing a lot of interest from institutional investors trying to get into this asset class both on the private and public sector. “Given where the equity markets have been over the last years and that some people are forecasting muted returns, there has been a big dive into the alternative asset class and real estate is an alternative asset.” JPMorgan Fleming’s Real Estate Group manages $26 billion of both public and private real estate assets. Rabenou adds that if you are a large institutional investor with a big pension plan owning either individual buildings or a private real estate fund, REITs are “clearly the most inexpensive and liquid way of getting additional diversification in your portfolio.” The most recent survey by the Profit Sharing/401K Council of /America shows that the number of plans with a REIT option had grown from 5% in 1999 to nearly 12%. Although attractive alternative investments, REITs are not risk free says Donohue.“Where there are some decent sized REITs, in the $10bn$20bn range, most are smaller

companies such as $100m-$2bn. They can be susceptible to two kinds of problems. The first is business risk. If the property has a bad time (such as malls that do not lease, office buildings that do not attract clients and apartment building with no tenants). Second is an interest rate movement.” Apartment REITs are particularly at risk in a soft economy, for example, because it is more difficult to command higher rents. Even so, it has to be kept in mind that while property income has been variable throughout the North American market, generally property values have either maintained their value or increased. And it is property values that most times drive REIT share prices. As to whether institutional investors will stay in once interest rates start to rise, David Loeb, managing director of real estate research at Friedman Billings & Ramsey (FBR) an investment bank that has raised over $5bn in REITs equity in 2004 (see FTSE Global Markets, Issue Three, “How far for FBR” pages 37-42), “We think REITs are pretty fully valued now relative to where interest rates are today. We think there is not a lot of upside given the current rate environment but that if long term rates begin to move up there could be some downside.” Loeb adds that though there has been a secular move to broaden ownership of REITs it will not be enough to offset the impact of interest rate rises. “We will see cap rates eventually rise and will make valuations look even richer and eventually see pension funds and other investors begin to go back into the stock and bond market in a big way.” In a high growth economy when corporate earnings are rising rapidly, says Loeb, “the slow growth of real estate looks relatively unattractive. I think there are going to be periods of

David Loeb, managing director of real estate research at Friedman Billings & Ramsey

that ahead which will create some volatility and a little bit of downward pressure on the REIT stocks.” He says, however, that because of strong dividend yields, they will be attractive to aging baby boomers looking for income in their portfolios. “We think there is very little price appreciation left and those strong dividends may offset a little of the price decrease in REIT stocks.” As to the performance of the various traditional property REIT sectors, Loeb says the retail sector has “by far the best growth prospects.”He also offers that hotels have been strong performers and in 2005 they will see “rapid growth.” He cites another trend for 2005 as the emergence of global REITs.“I think it is a good thing. We are seeing more of our domestic clients opening up global REIT funds and hopefully this will lead to more capital flowing and companies being formed overseas.” Meanwhile, Rabenou also sees a trend toward interest in overseas real estate markets and says JP Morgan Fleming has established a European presence through their London office. “People are starting to think about global REITs. There is a market that will evolve, but it will take some time.”

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

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In the Markets IN THE MARKETS

Warming to an upturn in European convertibles The outlook for convertible market valuations will likely improve in 2005. The balance of volatility risk is skewed to the upside and increased mergers and acquisition (M&A) activity should also benefit some convertibles. Issuance is expected to pick up, with extremely strong investor demand for attractivelypriced new issues continuing to support valuations. Luke Olsen and Haidje RĂźstau of Convertible Bond Research at Barclays Capital focus on the market drivers of European convertible valuations and the outlook for these variables over the near term.

ONVERTIBLE BONDS CONTINUE to appeal to issuers and investors, despite the lower issuance and lacklustre performance of the asset class in 2004. Through their exposure to equity prices, volatility, credit and interest rates, convertibles can be used in a wide range of investment strategies, a fact which has

underscored their popularity and usage. However, valuations will likely remain under pressure in the near term, finding respite only when equity volatility rises. Even so, new issues and special situations (such as a pick up in M&A, unexpected dividend news or issuance/tenders) may create additional trading opportunities.

Table 1: Overview of major convertible market drivers Driver Volatility Credit Swap rates Dividends Event risk Supply and demand

View

Expected impact

Stable to higher Stable to wider Wider Higher Higher Remain supportive

o/+ o/+/+ Source: Barclays Capital

A summary of the major factors affecting the convertible universe can be found in Table 1: Overview of major convertible market drivers and each of these elements are explained in greater detail below. Declining implied volatilities was the main reason for the underperformance of convertibles (on an outright as well as on a hedged basis) in 2004. Over the last eighteen months, volatility has slowly drifted downward, although it has not quite hit the lows recorded in the early to mid-1990s. Along the way, investors have periodically stirred up volatility levels, though only briefly. Indeed, looking at the implied volatility of near-dated S&P 500 index options through 2004, one can clearly identify earnings seasons. Nevertheless, the S&P 500 index remained within a

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In the Markets IN THE MARKETS

range of 100 points through 2004 and volatility has stayed on its overall downward trend. Looking ahead, the balance of risks is biased for a modest uptick in volatility in early 2005, with potential for a more significant boost around earnings season. Monetary and fiscal stimuli are waning and economic indicators do not yet signal the strong

Convertible bonds continue to appeal to issuers and investors, despite the lower issuance and lacklustre performance of the asset class in 2004.

economic performance that policymakers would like to see. As a result, capital could become more expensive – in the form of higher interest rates and wider credit spreads – both of which could lead to higher volatility levels. Indeed, interest rate hikes could increase uncertainty around equity valuations, making for higher realised volatility. Moreover,

higher interest rates make structured products more attractive and could also push longer-dated volatility higher (for example, capital guaranteed products generally involve the purchase of long-dated call options). As a result, we expect volatility to have a neutral to positive impact on convertible valuations in 2005. A further key valuation factor for convertibles is the issuer’s credit spread. Overall, we are optimistic on credit spreads going into 2005 as credit fundamentals remain strong and technical factors (limited supply and strong demand) remain supportive. We see systematic risk as relatively low, however, a sharp widening in government bond yields could potentially have a negative impact on the credit world. Otherwise, we expect credit risk to be mainly sector and name specific. Interest rates are expected to rise, which would negatively impact convertible bond valuations. Barclays Capital’s fixed income strategists expect swap rates to increase across the board, with the largest relative moves expected for five-year dollar swap rates – to rise by about 50 basis

Chart 1: Convertible bond issuance and redemptions in 2004 (€bn) 4

Issuance

Redemptions

2 0

points (bp) between January and March 2005. Five-year euro swap rates are expected to rise by around 30 bp over the same period while sterling five-year sterling swap rates should also rise by about 30 bp by March. Dividends are secondary valuation factors for convertibles but can nevertheless have a large impact on prices, particularly if dividend payments are large or unexpected. Overall, we think that dividends will continue to rise in the year ahead. Companies have delivered higher profits for several quarters now and many carry substantial cash amounts on their balance sheets. In the absence of attractive growth opportunities – whether internal or external – many companies have decided to distribute cash to shareholders. Any cash distribution that exceeds market expectations will negatively impact convertible bond valuations, unless the bond fully compensates investors for these payouts. Increasing dividends will therefore remain a negative factor in the coming months. Through the second half of 2004, event risk has selectively had a positive impact on convertible bond valuations as the resulting increase in expected volatility outweighed a potentially negative credit impact. Looking ahead, M&A could be a major driver of trading opportunities in the early part of 2005. Signs that activity is picking up are abundant,

-2 -4

Looking forward, the balance of risks is biased for a modest uptick in volatility in early 2005.

-6 -8 -10 -12 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Source: Barclays Capital

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In the Markets IN THE MARKETS

Chart 2. Credit Rating upgrades and downgrades for European convertible issuers November 2003-November 2004 10 9

Upgrades Downgrades

Looking ahead, M&A could be a major driver of trading opportunities in the early part of 2005. Signs that activity is picking up are abundant, particularly in the mining sector.

8 7 6 5 4 3 2 1 0 Food & Retail

Industrial

Insurance

Media & Publilshing

Misc

Technology

Telecoms

Transport & Leisure

Utilities

Source: Barclays Capital, Fitch, Moody’s, S&P

particularly in the mining sector. A further potential M&A hotspot could be the financial sector. However, M&A will not always be positive for convertible valuations – in particular, if an underlying equity is taken over for cash. In addition, some convertibles offer valuable compensation for investors in the event of a change of control (for instance, investor puts or conversion ratio/price adjustments). The convertible’s prospectus will detail any protection features for such scenarios.

Accounting treatment Significant changes to the accounting treatment of convertibles will come into play in 2005. EU companies will be required to report under International Financial

Supply and demand factors remain supportive of convertible bond valuations. Issuance between January and October 2004 was only 27% of 2003’s total and has been far outstripped by redemptions.

Reporting Standards (IFRS) / International Accounting Standards (IAS) for accounting periods beginning this year. Additionally, prior year comparatives will also be restated under IFRS. Even outside the European Union, many countries are adopting IFRS standards, for example, South Africa and Australia. IAS 32 and 39 deal with the accounting treatment of financial instruments, including convertibles. Under IAS 32, compound/hybrid instruments will be split into debt and equity components on the balance sheet. The bond portion is calculated by discounting the cash flows at the equivalent straight bond yield and the equity portion is the difference between the issue proceeds and the bond portion. On the profit and loss account (P&L), the interest cost will be shown as the cash interest (coupon) plus the accretion rate of the debt portion. This can result in a higher reported interest burden in comparison to many local Generally Accepted Accounting Principles (GAAPs), which only include the cash interest cost in interest expense. Depending on the tax regime, this might lead to a lower tax burden. However, for some convertibles (for

example, exchangeables, crosscurrency and cash-settled convertibles) the equity option component does not qualify for “equity” treatment under IAS 32. Instead IAS 39 requires the equity option to be accounted for as a derivative and carried at fair value with changes in fair value taken to finance costs in the P&L in each reporting period Supply and demand factors remain supportive of convertible bond valuations. Issuance between January and October 2004 (at €11.3bn is only 27% of 2003’s total of €41.3bn) has been far outstripped by redemptions, as shown in Chart 1: Convertible bond issuance and redemptions in 2004 (€bn). At the same time, continued strong demand for convertibles has remained supportive of valuations. Little change is expected here over the next few months unless either convertible issuance spikes up massively (which is unlikely given the modest financing needs of most European corporates) or sizeable redemptions by investors reduce the capital allocated to convertible strategies, (also unlikely, but could have a detrimental impact on valuations). If issuance remains far below the

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In the Markets IN THE MARKETS

when convertible arbitrage opportunities appear limited. As Chart 2: Credit Rating upgrades and downgrades for European convertible issuers November 2003November 2004 shows, the convertible universe remains dominated by BBB and unrated issuers. Compared to 2003, the proportion of BBB rated issuers increased at the expense of all other rating groups including unrated issuers. This was partly due to the fact that BBB issuance outweighed BBB redemptions (24% versus 13%) while The outlook for 2005 in the other rating categories issuance Overall, we think that the outlook and redemptions were more balanced. for this year is fairly promising and we Chart 2 also reveals that would expect an although unrated issuers are improvement on 2004’s Although there is room for optimism over the most numerous in our lacklustre performance, for universe, they account for less both outright and for credit performance over the next two hedged investors. This months, there are also concerns going into than 15% of the market capitalisation. If weighted by correlation is not 2005 as higher commodity prices, wage credit sensitivity, as surprising, given the inflation and higher funding costs could measured by the Price Value increasingly blurred weigh more heavily on corporate of a Basis Point (PVBP), BBBs demarcation between these still represent the largest two convertible investment performance. category, but single-A and strategies. One reason is higher-rated issues account that hedge funds take more and more outright views (on credit, convertible bond arbitrage strategies, for a combined 36%. Chart 3: Credit for example) to generate higher as convertible bond hedge funds may rating distribution of the European diversify into other asset class convertible bond universe by number, by absolute returns. The GSBB (Goldman Sachs/ strategies – for example, capital market capitalisation and by credit Bloomberg) European convertible structure arbitrage, commodities, etc – PVBP clearly illustrates these trends. levels seen in previous years, however, opportunities for convertible bond investors may diminish as redemptions continue to outpace issuance, resulting in cash outflows in the longer term. Potential drivers of issuance could be privatisations of state holdings, such as a new KfW Bankengruppe exchangeable, or the disposal of cross holdings – especially in Germany and Italy. Increased M&A activity is another possible driver.

bond index has returned 0.84% up to ‘December 2004, underperforming equities, corporate bonds and government bonds. Over the past twelve months, the index returned an even more disappointing -0.35% performance. CSFB/Tremont hedge fund data meanwhile indicates that convertible bond arbitrage strategies have returned 0.20% in the first ten months of this year and 2.16% in the past twelve months to October, thus underperforming overall hedge fund returns (5.12% year to date and 8.33% in the past 12 months). Note, this data might not accurately reflect pure

Chart 3. Credit rating distribution of the European convertible bond universe by number, by market capitalisation and by credit PVBP AAA 2%

Unrated 15%

Unrated 36%

A 16%

B or below 2% BB 3%

AAA 5%

Unrated 22%

AA 8%

A 15%

B or below 3% BB 4%

B or below 6%

BB 4%

BBB 29%

AAA 7%

AA 8%

A 21%

BBB 52%

BBB 35% Source: Bloomberg, Barclays Capital. Note: issue-specific ratings where available and issuer ratings otherwise.

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Regional Review NORTH AMERICA

New Rules for IPOs All five commissioners on the United States (US’s) Securities and Exchange Commission (SEC) voted unanimously in mid October to seek public comment on whether to ban practices such as laddering in which recipients of shares in IPOs would agree to buy more shares later in the market – ensuring the price of a hot IPO stock would continue to rise after its market debut. Karen Jones reports from New York. S PART OF its ongoing investigation and regulatory procedures regarding the Initial Public Offering (IPO) abuses during the technology and telecommunications bubble of the late 1990s, the SEC is proposing stricter rules for underwriters and greater transparency in the aftermarket. Once approved, these initiatives will become amendments to Regulation M, which was adopted in 1996 to “govern the activities of underwriters, issuers, selling security and others in connection with the offerings of securities” according to the SEC. The amendments would prohibit certain market activities that “undermine the integrity and fairness of the offering process, particularly with respect to the allocation of IPOs.” “The SEC is proposing to prohibit quid pro quo and tying agreements by prohibiting underwriters from conditioning an allocation of IPO securities on the investor purchasing the distribution securities in the aftermarket, purchasing securities in another offering or paying higherthan usual commissions on other transactions,” says Suzanne Rothwell,

a corporate finance and securities attorney at Skadden, Arps, Slate, Meagher & Flom LLP. She also spent twenty years with the National Association of Securities Dealers (NASD), a major regulator of the broker/dealer community. One contentious practice is ‘laddering’, where a potential investor is offered a hot IPO allocation only if they promise to buy more of its shares at higher prices in the aftermarket. The proposed amendment would expressly prohibit laddering and other ‘tying’ arrangements that tie the allocation of hot IPO shares with an agreement by the customer to buy shares in another less desirable ‘cold’ offering. Also up for consideration is strengthening rules regarding unlawful quid pro quo allocations where the condition of an IPO sale is based on an agreement to pay excessive trading commissions on unrelated securities transactions. “These proposals are meant to address numbers of IPO abuses that occurred in the late 1990s. Some, particularly laddering and other tying, were already prohibited by Regulation M. The SEC’s proposals would just

make the rule clearer,” says Rothwell, adding that the lack of clarity in the existing rules have not inhibited regulation response to abuses. Both the SEC and the NASD “have brought enforcement actions against broker/dealers and associated individuals for violations in respect to quid pro quo, tying, spinning and laddering.” She points out that the SEC staff made it clear that the new rules will not interfere with the underwriters’ freedom to allocate shares to its best customers and will not interfere with legitimate bookbuilding practices. She cautions,“It is important that the final rules are sufficiently narrow to only apply top manipulative activities and not inhibit legitimate distribution and trading practices.” Bruce Mann, senior partner at Morrison & Forrester, is an attorney who has specialised in IPOs since the beginning of the technology era. He was involved with the Intel IPO and offers that New York’s crusading District Attorney, Eliott Spitzer, (see FTSE GM, Issue Three, pages 33-36) would not have been conducting investigations if there were not a lot of

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Regional Review NORTH AMERICA

“perceived abuses” during the bubble selling to that institution, robs the would require that if the underwriter market for internet securities. “There company of $5 of value.“Unless there is buying shares to cover its short was a lot of greed during that period is a strong reason to justify it based on position, it is to be publicly disclosed which ran beyond what could be the company’s interest, it should not to the market in real time, similar to what is required for stabilising bids. be allowed,”concludes Mann. justified on an economic basis.” The proposal would prohibit the Proposed amendments also include Although he feels the suggested proposals are “going in the right a lengthening of the “restricted use of “penalty bids”which can act as direction,” the SEC has to decide period” for IPOs beyond the current an undisclosed form of stabilisation. which solutions are practical. “I think five-day period. The restricted period Penalty bids occur when an it is fair to say no one wants the is the time during which distribution underwriter reclaims a selling government to be allocating IPOs. The participants must refrain from activity concession from a syndicate member SEC doesn’t have the manpower or that could stimulate the market for the if the offering security is immediately the expertise and frankly does not security in distribution, says the SEC. sold by the initial purchaser. The SEC The new proposal would “begin when is also considering an amendment want to get into that,”he adds. recordkeeping in Mann also says it is clear that no the issuer reaches an understanding requiring one thinks underwriters should be with the underwriter to proceed with connection with the existing rule’s “de minimus exception” required to allocate IPOs which covers inadvertent “on a first come, first serve bids and purchases during basis” or on some basis that “There are a lot of perceived activities the restricted period that does not take into account going on that are inappropriate. This is total less than 2% of the that underwriters have action to try and more specifically prohibit distributed security’s average major clients and in the case trading volume of deciding who gets those activities. It is preventing preferential daily (ADTV). According to an allocated shares, those who treatment to people and enhancing the release, frequent do business regularly should integrity of the market as a whole when you SEC reliance on this exception not be prevented from don’t have these masking and clouding could indicate that a firm’s getting preferences. “That is market transactions.” compliance policies and the nature of business.” He procedures “are inadequate adds that if you have a to achieve compliance with valuable commodity, “you do not sell it to the person who walks a distribution.” The restricted period Regulation M.” Jonathan Boersma, senior director in the door who you have never seen could be as much as two to four before, you sell it to the people you months says Rothwell. “The issuer of professional standards of the have done business with and whose generally identifies its managing Chartered Financial Analysis Institute underwriter at the beginning of the (CFA) a non-profit organisation and a relationship you want to culture.” in promoting ethnics Mann confirms that he does not preparation of the offering and the leader think anyone wants to challenge this SEC’s offering review can take eight throughout the industry, feels the basic business principal. Instead he weeks or more,” she says. She is proposals will be advantageous to acknowledges that the SEC is waiting to see if the extended investors.“There are a lot of perceived focusing on abuses of that principal, restricted period will apply to only the activities going on that are such as economic benefits being given managing underwriter, “or if it will inappropriate. This is action to try and to “favoured clients of investment also apply to other co-managing more specifically prohibit those banks that really should go to the underwriters or other underwriters as activities. It is preventing preferential they are chosen in the period of time treatment to people and enhancing issuer of the securities.” the integrity of the market as a whole That said, Mann does not see any leading up to the offering.” Also under scrutiny is underwriter when you don’t have these masking justification in pricing an IPO “substantially below the demand buy backs or syndicate covering bids, and clouding market transactions. It is level.”If an individual is willing to pay a practice that has sometimes made it much better for investors when they $20 and a favored institution of the appear there is more demand for the have accurate information as far as underwriter is willing to pay $15, IPO than actually exists. The SEC trading volumes and pricing.”

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A seismic shift for US equity markets

welcoming the SEC initiative. The pertinent paragraph came early in the advertisement, from which the following quotation is drawn, explaining that the SEC is “nearing a decision on how to modernise (sic) our nation’s stock markets by overhauling outdated regulations that undermine the advantages of electronic markets. The Securities and Exchange Commission (SEC) of the United The benefits of forcing the NYSE to States (US) published a ‘concept release’ in early 2004 entitled compete fairly with these electronic Regulation NMS (National Market System) for public comment. markets are not just academic. We Resulting remarks have steadily escalated into a heated debate believe that introducing competition to on the right way to modernise America’s equity markets. the current archaic floor-based markets Although Regulation NMS is not likely to become a reality till will reduce investor trading costs.” NYSE’s chief executive officer (CEO) mid 2005, nearly all agree it will have a seismic impact on the John Thain in testimony before the US industry. Karen Jones reports from New York. Senate Banking Committee in July N EARLY 2004 the SEC announced competition in the stale US equity expressed his reservations. Certain its plan to modernise the American markets. Together with other SEC proposals “are inconsistent with our securities market. Four initiatives rulings, if passed, the regulation will goal of protecting investors, and we were tabled in the February NMS invariably result in a substantial believe they must be improved,” he release under the US’s 1934 Securities overhaul and increase in oversight of said. Thain’s key objection is to a provision by the SEC that will allow Exchange Act that addressed areas of those markets. It seems likely now that the certain institutions to forego giving growing contention in the securities proposals suggested in Regulation their customers the best price by opting market. The release has attracted no small NMS will come into play only after a out of the trade through rule. According degree of comment. The market is protracted period of debate and one to Thain’s testimony, the opt-out becoming increasingly noisy in its that ultimately will redefine the provision amounts to nothing less than sanctioning “overcharging”. advocacy or opposition to The NYSE however is not Regulation NMS. The “Although ECNs will benefit from alone in its concerns about the debate is such that it has implementation of Regulation split the equity markets and modifications to the trade through rule, indeed the SEC itself. It was allowing them to compete for listed order flow, NMS, although perhaps for different reasons. SEC inevitable it would do so, for they are “big” losers with access fee caps, commissioner Paul S. Atkins, two reasons. First if speaking at a Securities Regulation NMS is implemented it will alter, significantly meaning of the operation of free Traders’Association conference in Boca Raton, Florida in early October, was and structurally the operation of the markets in the US. Institutions are taking sides and it is candid about his own reservations, US equity markets. Second the regulation is a signal element in a a stand off that is pitting the New York telling delegates that he had expressed recent flood of SEC rules and Stock Exchange (NYSE) against some his concerns “during the Commission’s recommendations that have followed of the other exchanges. A loose public meeting to approve its release. I in the wake of the passage of Sarbanes consortium, for instance, that included specifically pointed out that the Oxley legislation in 2002. Sarbanes Ameritrade, Fidelity Investments, the proposed rule structure inserts a firm Oxley increasingly sees the hand of the National Stock Exchange (NSX), governmental hand into the operation US government in the operation of Instinet, NASDAQ and Bloomberg of the US markets.” However America’s financial markets. Singly Tradebook took out an advertisement in Commissioner Atkins made clear his Regulation NMS is an ambitious the Wall Street Journal in October this views were not and should not be read attempt to modernise and improve year to lay out their position, as those of the SEC.

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John Thain, Chief Executive Officer (CEO) of the New York Stock Exchange (NYSE)

Although the commissioner and indeed the SEC are still reviewing responses to the proposal, Commissioner Atkins’ concerns converge into a single question: “a philosophical one: when is it appropriate for the government to intrude in the marketplace, and specifically (sic), into the pricing of securities?”. Regulation NMS creates “more losers than winners”says Jodi Burns, an analyst with expertise in Electronic Communication Networks (ECNs), electronic equities trading and capital market structures at Celent Technologies, which recently released its own report on Regulation NMS. Jeff Brown, director of product development at UNX, says he would have been in favour of a much more simplified SEC proposal laying out broad guidelines for the industry and “leaving the details to the various market participants.” Brown describes Regulation NMS as being “over engineered” and “complex” with an open invitation for more government intervention. “It started as a relatively simple principal that limit orders should be protected and somehow we got to 250 pages of proposed regulation… The SEC is really micromanaging.”

Page 23

For the moment, the SEC proposals include four important elements. The first is a de minimus fee standard that will ensure non-discriminatory access to the best prices for quoted shares. This requires market centres, including ECNs, to provide non-discriminatory access to their quotes and limits any access fees to $0.001. Access fees are the subject of intense debate for two reasons. First they sometimes lead to artificial quotes. Second, the SEC believes that such fees have led to an increase in locked and crossed markets. ECNs will no longer be able to charge fees that prohibit or bar access to non-members. The second is a change in rules governing revenue from the sale of market data. Issues affecting the collection and sale of market information have attracted more than usual attention by the SEC. It should come as no surprise, as market data generated an estimated $424m in fees in 2003, of which £386m was distributed among exchanges and NASDAQ, according to Thomson Financial data.The rule would also lead to a new advisory committee that would comment on fees, procedures for fee administration and pilot programmes. The rule will allow the resale of data by exclusive processors on non-discriminatory terms. The third is a rule abolishing subpenny quotes and bids. This will stop market participants from accepting,

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

ranking or displaying orders, quotes or indications of interest in a pricing increment finer than a penny (except for securities with a share price below $1.00). Since the movement to decimals in 2001, spreads across markets have declined. Some markets round quotes to the closest decimal, while others continue with sub-penny increments. Economic studies by the SEC show that sub-penny quotes are just a fraction above or below the market and offered no real price movement. As a consequence, the SEC inferred that sub-penny quotes are used to obtain price priority. The fourth and final element governs a change in trade through rules. This is probably the most controversial of all the four proposals; the new rule extends trade through restrictions to all markets (including NASDAQ), but provides exceptions that will not require a market centre or broker to route orders to manual markets under certain circumstances. The existing trade through rule prohibits one market from “trading through” a better price on another market. New technology and changes in the structure of the securities market has called into question the old trade through requirements and the InterMarket Trading System (ITS – a system of linkages that connects exchange markets so that investors sending orders in one market can also access superior quotes offered in another

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market. Detractors complain that in some cases ‘superior’ quotes disappear when orders are routed out for execution and that the 30-second window that specialists are allowed to decide whether to execute against a quote is too long these days. Regulation NMS would add an“optout” clause allowing an investor to ignore the trade through on an orderby-order basis. Also proposed is allowing faster markets to ignore better prices by slow markets. Celent’s Burns says even though Regulation NMS is still a proposal, Exchanges are already changing their business models. The NYSE has been touting its new ‘hybrid’ market initiative that significantly updates its Direct+ automated system, while retaining its traditional floor brokers and specialists. Though the trade through rule will remain, the opt-out clause and the potential of allowing fast markets to ignore better prices could marginalise the venerable Exchange. Robert J. McSweeney, senior vice president, competitive position at the NYSE says Regulation NMS and the NYSE’s hybrid market “will have significant impact on how US securities are traded.”He adds that the NYSE hybrid market is designed to provide customers with “choices in terms of how they access liquidity.” Meanwhile, Alex Goor, president of broker-dealer Inet ATS Inc., says that ECNs have been “railing a long time against regulations that are supporting anachronistic trading exchanges such as the NYSE and the AMEX. We have been trying to convince regulators that the trade through should come down.” That said, he is “disappointed” that Regulation NMS will not only keep the rule but extend it throughout the industry. “For us, it provides a terrific illustration as to why we believe very strongly in free markets.” Commissioner Atkins most likely

Jodi Burns, analyst at Celent Technologies

agrees. During his Boca Raton speech, he stated: “the proposed trade through rule outlined in Regulation NMS is not a disclosure rule or a transparent form of regulation. In fact, it dictates how market participants must behave and interact with each other. When does dictating behaviour become micromanagement of market forces? What sort of, as yet unknown, unintended consequence will we see? How difficult will it be for the SEC to enforce?” He continues: “I have not yet heard a convincing explanation as to how the proposed trade through rule will be implemented in a non-standardised automated market. The technical problems associated with the timing differences between electronic data flows and order routing systems seems to create a labyrinth of issues. A truly effective trade through rule might only be possible in a standardised, centralised market.” Although ECNs will benefit from modifications to the trade through rule, allowing them to compete for listed order flow, they are “big” losers with access fee caps, maintains Celent’s Burns. Right now ECNs charge access fees to non-customers who route through ECNs. Fees vary,

but most charge $0.003 per share. Regulation NMS will cap fees at $0.001 per share and $0.002 per transaction. This represents a “66% price cut”on access fees, an important source of revenue for ECNs, confirms Burns. Exchanges and market makers will be permitted to charge these fees as well. Also, sub-penny quoting by ECNs provided a “competitive advantage.” This will cease with Regulation NMS. Exchanges will also lose revenue from transaction fees, which are subject to a cap. Other losers will be non-automated exchanges, which will be regarded as “slow markets” and vendors of smart order technology. Also, NYSE floor brokers and specialists “may be disintermediated as the exchange becomes more electronic.” Regulation NMS winners according to Burns, are those who spend a lot of money buying market data, which will now be less expensive.The large broker dealers will have a new revenue source by being allowed to sell their market data. Also, Self-Regulating Organizations (SROs) member firms will pay less for market data. Today, only SROs and Securities Information Processors (SIPs) can sell market data. However not everyone views this development so positively. Since exchanges started to share the market data revenue bonanza with their customers, participants have become used to pocketing rebates. Any regulatory change that affected rebates could, at worst, result in liquidity shifts between exchanges or dampen volume. Some exchanges are reportedly looking at profit sharing arrangements – an example that the NSX and NASDAQ have taken on board as a means of allocating market data revenues without creating distortive incentives. Nonetheless, regulators are keen to excise locked market practices.

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ASIA

Malaysia ups the ante again By the end of 2004 it was clear that Malaysia has begun to compete on more than even terms with China and even outclassed the Asian behemoth with an autumn season of serial private sector fundraising. Short-term hot money has also been flooding into the country to exploit the interest rate differential, which favours the Ringgit and a more flexible macro environment, which benefits the equity market. There is more to come as the companies and investors leverage the opportunities afforded by liberalisation and the growing diversification of the Malaysian financial markets. UYERS OF MALAYSIAN equities and bonds have been increasingly bullish through 2004 and look forward to a surge in private sector issuance in 2005. Telekom Malaysia’s recent debt issue was 2004’s benchmark, raising a $500m 10-year bond that was oversubscribed 8.5 times. The bond’s yield of almost 5.3% (112 basis points above 10-year US Treasuries) reflects the remarkably low risk premium that Malaysian issuers now attract. Other leading corporates have been eager to jump on the bandwagon. Mid-September saw gaming concern Genting raising $300m in 10-year bonds, followed only days later by a $110m convertible-bond issue by Commerce Asset Holding. October then released local low cost carrier AirAsia’s initial public offering (IPO) of 700.5m shares to Malaysian and foreign institutional investors. This was supplemented by an additional 140.1m shares in a public offering, prior to a listing on Bursa Malaysia in late November. The float raised approximately RM717m for the airline. Credit Suisse First Boston (CSFB) was sole bookrunner and lead manager for the international institutional tranche while RHB Sakura Merchant Bankers Berhad (RHB) and ECM Libra Securities took joint book running roles for the domestic institutional tranches and were joint managing underwriters for

the public offering. While many other maintaining the momentum. Investor emerging markets had seen sentiment has improved as a result of something of a dampening of interest, continued reform measures and fiscal AirAsia’s IPO showed that appetite prudence as well as improved oil for Malaysian equity and debt had not receipts and a sustained growth dissipated despite a strong year for performance. Even so, the 2005 Malaysian issuance. The IPO was 3.5 financial year budget is mildly times oversubscribed. Between January and end of November 2004, some 63 companies listed on Bursa Malaysia’s Main Board, Second Board and the Malaysian Exchange of Securities Dealing & Automated Quotation BHD (MESDAQ) Market. “All were oversubscribed,” says Yusli Mohamed Yusoff, chief executive officer (CEO), Bursa Malaysia. “That is, over 34% of the 63 counters were 50 times over-subscribed and over 13% were 100 times oversubscribed, except for one.” Without a doubt Malaysia is on a roll. It is estimated that Malaysian firms could issue up to some $8bn worth of bonds in 2005, well up on 2004 issuance volumes. The Yusli Mohamed Yusoff, chief executive officer (CEO), Bursa trick will be Malaysia

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FTSE Asia Pacific All-Cap Index vs FTSE Malaysia All-Cap

Index Performance (Rebased)

120 115 110 105 100 95

4 c-0

vNo

t-0 Oc

04 pSe

04 g-

FTSE Asia Pacific All-Cap Index

l-0 Ju

04 nJu

-0 ay M

r-0

4 Ap

-0

04 M

bFe

04 nJa

c-0

FTSE Malaysia All-Cap Index

Data as at 1st December 2004. Source: FTSE Group

contractionary, as total expenditure is projected to decline from RM122bn bn in 2004 to RM117bn in 2005. Government investment (development expenditure) continues to bear the brunt of the decline, dropping from RM31bn in 2004 to RM28bn in 2005. With this level of fiscal consolidation Malaysia will try to leverage the private sector consumption and investment as the country’s growth engine. According to Yusli Mohamed Yusoff “While private investment has not matched private consumption in terms of size and rate of expansion, it is expected nonetheless to grow 14.8% in 2004, based on nascent signs of recovery.” “The general feeling is that the economy is well balanced and positioned without too much input from the government. The economy is growing at around 7% with little or no priming on the government’s part,” says Zarir J. Cama, deputy chairman and CEO at HSBC in Malaysia.“Their feeling is, let the private sector get on with it.” Selective opening of the financial system is another feature of this latest budget. The authorities now allow full

foreign ownership of futures broking companies and venture capital firms, as well as participation by five foreign stockbrokers and five foreign global fund managers. The present limit on the number of foreign dealer’s representatives in the stock-broking industry is also being abolished. “While the opening up of the stockbroking industry to major foreign brokers would undeniably increase competition and efficiency, it would also create a landscape for more merger and acquisition activities in the sector,”says Yusli Mohamed Yusoff. “The measures send a powerful message to domestic and foreign investors.” The government also announced impending tax changes for 2007 in the budget. Sales and services taxes are to be replaced by a much broader goods and services (GST) tax based on a value-added-concept and will pave the way for the government to lower income-based corporate and personal taxes from 2007. Eyes now are on the Ringgit. The currency has broadly been undervalued on a trade-weighted basis for some time, but particularly over the

past two years when the US dollar has been under pressure and continues to depreciate against most major currencies. Belief in a Ringgit revaluation has pushed the Kuala Lumpur Composite Index to an eight month peak as short term hot money has flooded in. While some analysts think that there will not be a change in the peg until the middle of 2005, others think it will come sooner. The Malaysian government had fixed the ringitt relative to the US dollar in September 1998, at RM3.80 to the US dollar, when Prime Minister Mahathir Mohamad imposed capital controls to halt a slide in the Ringgit during the Asian financial crisis. Any move by Malaysia on currency will depend on China’s lead. According to Bursa Malaysia’s Yusli Mohamed Yusoff, “Such speculation about a Ringgit revaluation has cropped up before. And the Ringgit peg has remained unchanged. What I know is senior government officials, including the Prime Minister himself, said recently that the peg will be maintained although Malaysia continues to closely monitor developments.” “I expect the pressure will build up, especially with the possible revaluation of the Remnimbi. The question is will Malaysia act unilaterally? I think it unlikely. It is important to see by how much China will revalue by and all this can happen much earlier than people think,” suggests HSBC’s Zarir J Cama. Current interest rate mechanisms, he reckons are all steps on the way to full convertibility. If the peg does loosen he personally thinks that the Ringgit will settle somewhere between $1/RM3.30 to $1/RM3.40, “That’s about the floor, I would think, although I’m not willing to commit. Unfortunately, I don’t have a fully operational crystal ball,”he jokes.

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IFC leads issuance charge following market reforms Following the 2005 budget, important changes to Malaysia’s financial market are in train. Institutional issuers have been quick off the mark to capitalise on the changes. Francesca Carnevale reports.

bookrunners and marketed the debt securities to both local and foreign investors. HSBC Malaysia Berhad’s deputy chairman and chief executive officer (CEO), Zarir J Cama says,“IFC’s leadership on the issuance of this Islamic security will … certainly encourage other non-Islamic supranationals to consider financing via Islamic instruments”. HE INTERNATIONAL FINANCE As 2004 drew to a close, the IFC Corporation (IFC), the private issue set a seal on the Malaysian sector arm of the World Bank government’s efforts to further Group which promotes sustainable liberalise the Malaysian capital private sector investment in markets and, in particular, to promote developing countries, launched its Islamic finance. In a series of measures inaugural RM500m Ringgitannounced during the 2005 denominated Bai Bithaman budget, the government will Ajil Islamic Securities in early establish an international December in the domestic “IFC’s leadership on the issuance of this financial training institute to Malaysian capital market. The Islamic security will … certainly encourage develop local expertise in bonds are the first Islamic other non-Islamic supranationals to consider Islamic finance and tax and issue by a supranational financing via Islamic instruments” duty exemptions are now institution in any domestic given to Islamic financial capital market and the IFC’s and capital market products first Islamic issue in the To help Malaysia further develop to diversify the local Islamic financial institution’s 2004 funding programme, which is worth around Islamic securities in the domestic system. The IFC bond took advantage capital market, IFC decided to make of this tax exemption. $3bn a year. A tax exemption is given on interest IFC issued the bond after close its debut in Malaysia with an Islamic consultation with the Malaysian issue. The structure will “establish income derived by non-resident benchmarks and companies from both RinggitSecurities Commission, Bank Negara pricing Malaysia, the central bank, and the documentation that would encourage denominated Islamic securities and Malaysian Ministry of Finance. The further issuances of Ringgit bonds by debentures (excluding convertible issue is the first by a multi-national MDBs and MFIs,” said Nina Shapiro, loan stocks approved by the institution following the recent Vice President, Finance and Treasurer Malaysian Securities Commission) and securities issued by the relaxation of issuance rules, of IFC shortly after the issue. HSBC Bank Malaysia Berhad government. “Added to this, the announced in the 2005 budget, which now allow Multilateral Development (HSBC) and Commerce International government has issued three more for Islamic banking Banks (MDBs) and Multilateral Merchant Bankers Berhad (CIMB) licences Financial Institutions (MFIs) to issue were joint lead managers/joint operations to be established in the

Ringgit-denominated bonds. The IFC is well known in the international capital markets for issuing securities in currencies other than US dollars and Euros. IFC’s securities, which are rated Aaa by Moody’s and AAA by Standard & Poor’s, have been issued in 30 different currencies. The agency is among the first, non-resident institutions to issue in many currencies including Spanish pesetas, Portuguese escudos, Colombian pesos, Hong Kong dollars and Singapore dollars in respective domestic markets, and in Philippine pesos, Czech koruna and Polish zloty in offshore markets.

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country,” says HSBC’s Zarir Cama. “The measures should be seen in the light of the government trying to put Islamic finance on a par with traditional western financing structures. It is giving the issuer and investor free choice. You shouldn’t really look at this as exemptions, but rather a neutralisation.” The move is significant however and will be seen as a way to open the market further to large Islamic financing structures. The way was largely paved in 2004 when HSBC led the Optimal-Petronas-Dow Chemical project financing, which was Malaysia’s largest project financing of the year. Interestingly, the deal mixed western and Islamic financing structures, with a US dollar syndicated credit supporting an Islamic bond, worth RM1.72bn over eight years. “It is only the start,” predicts Zarir Cama. “Islamic convertibles will also grow to become a significant element in this market. It is a tremendous opportunity for the country and for issuers, who will have an enviable range of financing opportunities available to them.” A further promising element of the 2005 budget was the decision by the Securities Commission to open the country's stock-broking business to foreign-owned companies. Up to five major foreign stockbrokers will be allowed to operate in Malaysia. Additionally, local stockbrokers that have merged with at least one other stockbroking company can now establish four additional branches. Full foreign ownership is now also allowed in futures broking companies. The limit on the number of foreign dealer representatives will also be abolished. Though outsiders will be permitted to engage in institutional trading only, they will be eligible for a share of the lucrative business of managing part of the $42bn Employee

Provident Fund (EPF), a compulsory retirement scheme that the government is gradually outsourcing to the private sector. A limited number of global fund managers will now also be able to operate in Malaysia. EPF will also be allowed to increase the size of its fund allocation placed with local fund management companies, including non-bank owned companies, from RM6bn to RM12bn within the next three years. Additional foreign venture capital firms will be allowed to provide up to 100% financing for local start up companies. The corporate sector will also benefit from liberalisation. The government’s anti-corruption campaign will continue. “Not only will this win back local confidence, but it should also improve investor confidence,” says Bursa Malaysia’s CEO Yusli Mohamed Yusoff. In addition, he says that efforts to improve ties between Malaysia and fellow Association of Southeast Asian Nations (ASEAN) and particularly with Singapore are underway. This will provide “more opportunities for cross-border mergers and acquisitions. The recent TemasekTelekom Malaysia deal is a good example, signalling the government’s increasing willingness to approve cross-border deals.” Telekom Malaysia Bhd (TMB) has been given the responsibility to oversee the national telecommunication company’s foreign forays to its wholly-owned subsidiary, Telekom Malaysia International Sdn Bhd (TMI). TMB is reportedly planning to acquire a 33% stake in India's fifth largest mobile company, Idea Cellular. The government’s efforts to divest some of the government's holdings in private companies are attracting attention from international investors. Through the state investment arm

Zarir J. Cama, deputy chairman and CEO at HSBC Malaysia Berhad

“Full foreign ownership is now also allowed in futures broking companies. The limit on the number of foreign dealer representatives will also be abolished.” Khazanah Nasional, the government enjoys controlling shares in a large group of companies that together account for almost half of Malaysia's $110bn stock market capitalisation. The government signalled its commitment to divest its diversified interests in early March 2004 when it gave the green light to Khazanah to shed its stake in Telekom Malaysia. The deal involved selling a 5% stake to Temasek Holdings, the Singapore government's investment arm. The move is significant not just for the political repercussions of a crossborder deal but it also signalled that Khazanah is becoming an independent institution. In the past it has often been regarded as an investor of last resort, providing support to ailing companies.

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CHINA

After a shaky autumn Chinese IPOs are back in style as investor appetite for Chinese shares returns. Airlines and the telecommunications sector are two immediate beneficiaries of the turnaround. HERE HAS BEEN a noticeable pickup in Chinese company equity issues and IPO activity through November and early December – something of a turnaround from the summer and autumn months, when issuers (particularly in the telecommunications sector) were reporting delays in coming to market. The autumn downturn was in part a consequence of investors becoming increasingly selective of Chinese shares and, at home, as credit tightened, selected business sectors (particularly wireless, automobiles and spare parts) began to feel the pinch – even more so after the government introduced a modest hike

in interest rates in late October. By early November, however, the mood had changed and New York and Hong Kong registered renewed interest in Chinese IPOs and secondary listings. The latest in a heady run of lateautumn offerings came in early December, with the debut of 141m shares in ZTE, China’s second largest telecom provider on the Hong Kong Stock Exchange (HKSE), raising $398m. The company, which has annual revenues of around $2bn, has been listed on the Shenzhen Stock Exchange since 1997. As a consequence the deal was massively oversubscribed prior to its listing on December 9th, leading to a reported

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IPO market makes a comeback

clawback in retail share allocations. Funds raised by ZTE will be used to expand its sales in emerging markets, such as India, Iraq, Pakistan, Romania, Egypt and Brazil, which are currently responsible for some 13.4% of ZTE’s overseas sales. According to the listings preamble and documentation, the move to overseas markets is important for the provider as revenue from wireless communications, which accounts for around 46% of ZTE’s revenues in China, may decline over the short term as the government plans to develop high speed mobile phone services instead.The wireless sector has been particularly vulnerable to changes in government policy on telecommunications technology over the last 18 months and a number of domestic firms have suffered setbacks as a result. Back in September, for example, Cellstar Corporation had to shelve its plans to debut the shares of its Chinese subsidiary on the HKSE. In part, said Cellstar staff, due to weakness in demand. ZTE itself had not been immune to the vagaries of government policy. It had planned to list on the HKSE back in April 2003 but it had to withdraw its listing due to unfavourable market conditions. Goldman Sachs is acted as book runner on the listing, replacing JP Morgan which was originally mandated back in 2003. China Netcom Group (Hong Kong), a subsidiary of China's second-largest fixed-line phone operator in China finally achieved a double listing in both New York and Hong Kong in early November (see Table 1: Recent Chinese IPOs and Secondary Listings). It was a close call. Back in July things had looked differently for the firm, as the investment in the telecommunications sector still looked uncertain. Like Cellstar, China Netcom, had hoped to come to market in September, but had to delay until November, when it was

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deemed that investor appetite for Chinese telecom shares had reignited. In the end the company raised $1.13bn to fund expansion and even managed to attract orders worth over $16bn, according to press reports in Hong Kong. However, initial market reports had variously estimated that the company would raise between $1.5bn and $2bn between the two market listings, which patently did not happen. China Netcom had been the last of China’s big four telecommunications majors to come to market. The company issued American Depository Shares (ADS) in the United States (US), which closed 14% higher on the first day of trading. Even for smaller deals timing and sector are dominant factors in determining the success of China’s burgeoning IPO pipeline. Recruitment firm 51job Inc.’s IPO raised a relatively modest $73.5m readily in its debut on NASDAQ in October, for example – likely due to the perception that demand for job search services in the Chinese labour market will continue to expand. Most Chinese firms that list in the US use American Depository Receipts

China (ICBC), Agricultural Bank of China (ABC) and China Construction Bank (CCB). Together they account for around three quarters of the country’s total banking assets. However, while apparently hugely attractive, all four banks still suffer from nonperforming loans and work still remains on effective restructuring of the banks’ portfolios. In the interim, China’s better performing banks have seen their shares sold through private sales, for example BNP Paribas’ purchase of a 50% stake in the International Bank of Paris and Shanghai, now renamed BNP Paribas (China) Ltd. Air China meantime, will cap 2004’s issuance calendar with a planned HK$8.7bn IPO, equivalent to around $1bn, in mid December involving a dual listing in Hong Kong and London – one of the first such dual listings in recent years. Air China will also be the third mainland carrier to list in Hong Kong. The airline holds a majority stake (approximately 70%) in China National Aviation Company, which is already listed in Hong Kong. Local carrier Cathay Pacific has

(ADRs) or list as foreign filers. This means that they are subject to less stringent Securities and Exchange Commission (SEC) disclosure regulations. Despite these weaker reporting requirements, some of China’s highest grossing IPOs, such as PetroChina, China Life and China Unicom, listed as ADRs. The less stringent reporting requirements has not dampened demand for Chinese shares in the US and now almost 80 Chinese companies are listed on either the New York Stock Exchange or the NASDAQ. The marked improvement in investor appetite for Chinese IPOs is expected to run through the first half of 2005, during which time some key companies are expected to debut, including Bank of China (BoC). BoC’s IPO is expected to lead a phalanx of Chinese banks looking for growth capital to issue in both Hong Kong and overseas during 2005 – a year in which issuance volumes are expected to top $15bn. China’s banking sector is dominated by the country’s top four commercial banks, including the BoC; Industrial and Commercial Bank of

Table 1: Recent Chinese IPOs & Secondary Listings Market Founded Cap 1985

IPO/Issue Date 6/12/04

Share price Lead Manager/ at launch Co-lead Manager $22.00 Goldman Sachs

Company Name ZTE Corp

Business Telecoms

eLong

Travel services 2001

$576.3m 28/10/04

$13.40

China Finance Online

Financial data 1998

$286.8m 15/10/04

$13

China Netcom Group

Telecomms

1999

$7,918m 11/10/04

Ninetowns Digital World

Software

1995

$392.1m 12/3/04

Deutsche Bank Securities JPMorgan

Comments 141m shares. Secured $10bn in retail and $7.6bn in institutional demand. 4.6m ADS – upped from 4.39m

6.2m shares issued Final share price 18% above expected range $21.82 (US) Goldman Sachs, Issued 52.3m ADS in the US $8.91 (HK) China International One of HK's most heavily traded Group/Citigroup counters in the aftermarket. $11.00 JPMorgan 9.6m shares Citigroup

Exchange HKSE

NASDAQ

NYSE HKSE NASDAQ

Sources: IPO Home by Renaissance Capital/Finance Asia

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CHINA reportedly already secured a strategic stake in Air China worth up to 10% of its total equity, while Shandong Airlines and Japan’s All Nippon Airways are also said to be interested in buying substantial shares. The carrier is China’s fastest growing airline in a faster growing market (currently expanding at over 12% a year) and enjoys a 21% market share. It is planning to buy some 46 new planes to add to its 136 strong fleet to meet growing demand at home and abroad. Monies from the IPO will part finance these purchases as well as the construction of a new terminal. Expansion and developed are priorities for Air China. Competition for low cost carrier business in China is heating up. The carrier already competes with China Southern Airlines and China Eastern Airlines, but that relatively cosy set up is unlikely to last. Shanghai Airlines, for example, which is already listed on the Shanghai exchange, is said to be ready to set up a low cost carrier to compete directly with Air China and international airlines permitted to open up new routes in China include Cathay Pacific, United Airlines, Air France-KLM Group and Germany’s Lufthansa.

Air China will offer 2.81bn shares, involving around one third of the company’s total shares, priced between HK$2.35 and HK3.10, equivalent to around 30-40 cents per share, which is underwritten by China International Capital Corporation and Merrill Lynch Far East. The IPO will bring the market value of the carrier to around $2.5bn.

Competition for low cost carrier business in China is heating up. China Air already competes with China Southern Airlines and China Eastern Airlines, but that relatively cosy set up is unlikely to last. Shares already listed in sectors less susceptible to government credit and policy squeezes continue to show remarkable progress. Yanzhou Coal Mining Co. and oil driller CNOOC Ltd shares, for example, continue strongly as China’s demand for energy rises inexorably. Growth in China continues to be driven by investment – although demand

remains buoyant, particularly in the energy sector. Under China’s fixed exchange rate system (where the Yuan is pegged at Y8.28 to the US dollar) funds coming into the country are immediately converted to Remnimbi which, in turn, has boosted money available for investment. The government is replete with foreign exchange reserves of over $514.5bn, a growing capital account (the balance of transfers of funds in and out of the country) of $66.8bn and a current account (the balance of transfers of funds plus trade in goods and services) surplus some $7.5bn. To a modest degree the government has been successful in introducing some cooling. Gross domestic product (GDP), in line with World Bank predictions, is reportedly down to 9.1% in the third quarter (Q3) from 9.6% in Q2. “China's domestic demand remains strong but underlying inflationary pressures are limited. This reduces the possibility of further drastic macroeconomic measures to cool down the economy and land hard,” according to the bank’s latest East Asia and Pacific Regional Update. The bank's forecast rate for China's economy in 2005 is 8%.

Table 2: Chinese IPO & secondary listing pipeline

Company Name Air China

Business Air Travel

Market Founded Cap n.a. $6.7bn (approx)

IPO date expected 12/12/04

The9 Limited

Gaming

1999

$325.9

13/12/04

Fu JI Food and Catering Catering

1999

n/a/

10/12/04

Share price Lead Manager/ range Co-lead Manager HK$2.35 China International Capital Corporation Merrill Lynch $13-$15 Bear Stearns CIBC Word Markets CAF Securities SBI E2 Capital

Comments First joint listing between Hong Kong and London for some time

HKSE LSE

6.25m ADS offered

NASDAQ

100m new shares raising $32.5m HKSE 2005 P/E. Post IPO the private equity arm of CLSA will convert a $4m convertible bond into an 8.39% equity stake in the company.

Sources: IPO Home by Renaissance Capital/Finance Asia

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The Green Shoots of QDII are yet to show The markets are still waiting on government approval for qualified domestic institutional investors (QDIIs) to enjoy a more liberal investment regime. The issue is said to have split the government and bankers are reluctant to get into the mix as to why the QDII scheme is being delayed. HE CHINESE GOVERNMENT appears to be in a quandary over the implementation of the long awaited QDII scheme, which would allow domestic investors to buy foreign stocks and bonds. Certainly, no one in the banking community is talking: “I would need official sanction to talk about this,” says an American banker in Beijing, “but in this climate it is unlikely I would get it. It is too sensitive.” The reason for the sensitivity is increasing pressure on the authorities to revalue the Remnimbi (see FTSE Global Markets, Issue Two, July/August, page 6). The country is bowing under a massive foreign exchange surplus. At the end of September, foreign exchange reserves stood at a record $514.5

billion, double the US$212.2bn held in reserves at the beginning of 2002. This will likely mean that the issue of QDIIs will not be visited until at least the middle of 2005, suggests a spokesman for China’s Xinhua News Agency in Beijing. The National Council for Social Security Funds (NCSSF), the central mandatory body in charge of $16bn of social security funds, is awaiting approval to be allowed to invest in overseas markets utilising its foreign exchange capital. NCSSF is widely regarded as a new institutional investor force in China's stock market. And it is also expected to be one of the first domestic institutions to enter the overseas capital market, since it already received State Council

initial approval for overseas investment back in February 2004. But so far, the fund’s asset managers can only invest in mainland securities. Nonetheless, the NCSSF remains optimistic and through the summer months began a process to choose eight new fund managers to help with its future investments. According to the Xinhua News Agency, insurance companies are now also expecting the go ahead to use foreign shareholder capital to invest overseas. If approved, the moves still fall short of allowing domestic investment institutions full access to the international capital markets. The China Securities Regulatory Commission (CSRC) finished a draft proposal outlining the permitted activities under the QDII programme

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CHINA at the end of May 2004. Together with the State Administration of Foreign Exchange (SAFE), CSRC is among the leading supporters of the opening up of the domestic investors’ market. It wants to allow mainland companies and individuals to buy shares in markets in Hong Kong and overseas companies. However the market still remains unclear as to what mainland investors will be actually allowed to buy once the QDII scheme is approved. In Hong Kong it is widely assumed that when eventually approved, QDIIs will also be allowed to invest in red chip, SOE (state-owned enterprise) and blue chip stocks listed in Hong Kong. But this has not been confirmed by the Chinese authorities. In the still limited CSRC proposal, certain domestic institutional investors will be allowed to establish closed investment funds denominated in foreign currencies for investing in Hong Kong stocks. The investment cap and duration of each institutional investor will be restricted so as to facilitate supervision by the SAFE on the flow of capital. It would also be a natural partner to the current Qualified Foreign Institutional Investor (QFII) which allows approved

foreign investment institutions controlled access to China’s A shares listed on the Shanghai and Shenzhen stock exchanges. Off the record, bankers say that intense opposition from the domestic stock markets who fear a massive outflow of Chinese investment dollars is behind the delay. Between Y50bn and Y80bn is variously reckoned to have already flooded into Hong Kong this year, as Chinese investors find alternative routes to invest in foreign stocks and bonds. “It is hard to say if the draft (regulations) will even be approved in early 2005,” says a foreign banker in Hong Kong. “On the other hand, they could make a decision very quickly.” Ironically, while the Chinese government is reluctant to revalue the Remnimbi, approval of the QDII programme may provide it with an outlet to reduce foreign exchange levels overall. Balanced with that is the inevitable dampening effect the introduction of QDII will have on the value of A and B shares; although some analysts suggest that the implementation of QDII will bring about a necessary rationalisation of the alphabet of Chinese shares or at

the very least force an effective merger of A and B shares. International investment managers think that the introduction of QDIIs is inevitable; it is just a matter of when. Of more salient interest is the remaining overhang of state shares in the listed companies that still make up the bulk of the Shanghai and Shenzhen exchanges. Opportunities abound for the privatisation of these companies, in either full or partial sell-offs. But for the moment, the consensus is that this move might be too rich for the Chinese authorities to accept. More than half of Chinese mainland listed companies have the State as a shareholder. Change here may also be a long time in coming. Neither the CSRC, or the State-owned Assets Supervision and Administration Commission of the State Council, have publicly endorsed a specific plan to reduce state control of the country's listed firms. To date China's authorities have indicated they would prefer to sell state shares to private investors through placements, using a separate mergers and acquisitions market to determine the value of that equity rather than through share offerings.

China’s Stock Market – Overview 700 600 500 400 300 200 100 0 1992

1993

1994

1995

1996

1997

Total Market Cap (USD billion)

1998

1999

2000

2001

2002

2003

Sep,04

Free Float Market Cap (USD billion) Source : FTSE Xinhua Index 29th October 2004

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SPECIAL REPORT: CHINA

Investors keen to be involved in China’s growth are now able to choose from a more diversified set of investment products. As well, after a rocky 2002/2003, mutual fund investments in China are beginning to show sizeable returns. With an economy set to expand by around 8% in 2005 China is now enjoying sustained and unprecedented investment. More importantly, confidence is building in China’s domestic fund market – with an attendant easing of overseas investment restrictions on the insurance sector. How long can the good times last?

More choice for investors CCORDING TO LIPPER Analytics the 22 China regional funds, with assets totally just under $2bn had average returns of 5.2% in the third quarter of 2004. Returns over the year average an impressive 16.5%, while the two year return is almost 30%. At the beginning of the year Lipper reported that the

average China fund gained 63% in 2003 and looks set to do the same or better this year. The performance of the Matthews China Fund which puts around three quarters of its money into mainland China followed this pattern almost to the letter, with an average 24.5% return over three years and a 65% return in 2003 – though it

nowhere near came to meet the performance of Templeton’s closed end Dragon Fund, which returned over 100% last year. China, it seems, can do little wrong at the moment. Additional market reforms and market liberalisation, such as the loosening of its rather tight currency controls, would make inward investment even more attractive. For many investors, the most recognised way to invest in China is through a mutual fund. The number of offerings is growing as investor demand for China-related products increases. Mutual funds are highly attractive as they often have a large percentage of their holdings in Hong Kong, Taiwan, and sometimes even Singapore, to hedge against the risks inherent in an entirely mainland based portfolio. Very obvious limitations on the free movement of

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Special Report:

CHINA ETFS: THE EASIEST WAY TO INVEST IN CHINA

T THE BEGINNING of October, the London Stock Exchange introduced four Exchange Traded Funds (ETFs), covering indices in China, Japan and European small and mid cap companies. Of the four, the Chinese ETF caused a stir, as for the first time, gave UK retail investors a cost effective way to invest in Chinese shares. At the same time trading in ETFs on the exchange were all transferred to SETSmm, the Exchange’s trading platform. Martin Graham, Director of Market Services at the London Stock Exchange, said at the launch: “ETFs are not yet as widely-used in Europe as in the United States, but interest is continuing to grow. We believe the improvements we have made to trading arrangements will result in better liquidity, helping to make them an even more attractive investment.” Hong Kong remains a strong favourite for new China ETFs, the latest being the FTSE/Xinhua China A50 Index, offering investors access to the A share market in China. Designed to track the FTSE/Xinhua China

capital in and out of China, continued centralisation of decision-making, and a lack of clarity in areas such as fund regulation and, indeed, corporate governance, mean that political risk in the country is still relatively high. In spite of the risks and because of the returns achieved, the last three years have inevitably seen a crush of new mutual funds. Among the latest is Gartmore’s China Opportunities Fund, which was launched in September. Additionally as confidence in the market grows there are more additions to the pot of 23 Qualified Foreign Institutional Investors (QFIIs). Fortis Investments became the latest fund manager to be granted QFII status, covering a $100m investment quota in China’s Renminbi denominated A shares and bond markets. The quota was awarded in late November and the fund now has three months to invest its quota. The money will be channelled

A50 Index, the A50 Tracker holds the top 50 A shares that trade on the Shanghai and Shenzhen exchanges. According to Deborah Fuhr, executive director, at Morgan Stanley in London, “index products give you diversified exposure and I think this ETF is the first of many of its kind. BGI has found a way to give investors access to A shares. It is innovative. More products will undoubtedly move to China and it may be that we will also see cross-listing of ETFs.” Efforts to expand the menu of exchange-traded funds and make them more accessible to smaller investors have received a lot of attention recently. Some of the more prominent new funds include the first mainland China ETF and several new Vanguard sector ETFs. There aren't many mutual funds offering pure exposure to China, and this ETF's 0.74% expense ratio is much cheaper many of them. ETF’s provide an easier way to negotiate China as government ownership of many enterprises, an alphabet of various company share classes, and boom-bust atmosphere can make it a win or lose location for investors.

through a Luxembourg domiciled Sociétéd’invesstissement à Capital Variable (SICAV – literally translated as a variable capital investment company.) in 30 to 40 quality growth stocks listed on the Shenzhen and Shanghai exchanges. The move

At the beginning of the year Lipper reported that the average China fund gained 63% in 2003 and looks set to do the same or better this year.

brings the total of investment quotas awarded under the QFII scheme to just under $3bn, according to the State Administration of Foreign Exchange (SAFE), China’s foreign exchange regulator which grants investment quotas. Fortis’s quota was not,

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

however, as large as the quotas awarded to UBS Limited, Citigroup Global Markets and Nikko Asset Management in September, who were given quotas of $200m. A further eight companies are said to be awaiting QFII status, while more than half of the firms already awarded the status are now asking for a doubling or at least an increase in their quotas. To qualify to invest in A shares a foreign financial institution must have $10bn in assets under management and been in operation for over five years (insurance companies and brokerages on the other hand must have 30 years of working experience and at least $1bn in assets). To limit the outflow of hot money in and out of China, the QFII scheme requires investment houses to keep funds onshore for at least a year before repatriating profits and capital. Domestic asset management companies have also enjoyed success

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SPECIAL REPORT: CHINA

over the six years they have been allowed to operate in the country. As of the end of June 2004, the Chinese domestic fund management industry realised over RMB30bn in dividends, with ChinaAMC among the best performers. Currently the volume of assets under management by Chinese domestic fund managers is around RMB300bn, accounting for 25% of the tradable value of all A shares listed on the Shanghai and Shenzhen exchanges. Fund management is a booming business in China. By August 2004, 40 domestic fund management companies managed over 146 funds, including 54 closed end funds and over 90 open ended funds. Around a third of the open-ended funds were

established in the first half of 2004, with combined assets under management of some RMB140bn. Together the assets of both closed end and open ended funds now accounts for just under 3% of China’s gross domestic product (GDP). Compare that with the fund industry in the United States (US) which encompasses over 8,000 funds and assets under management of just under $7.5trn, representing 67.5% of US GDP. Insurance companies dominate the Chinese closed end funds market, accounting for around a quarter of the assets under management in the sector. With China's immense private savings of RMB6.21trn (approximately US$750bn) the current crop of

Chart 1: Rapid Growth in China’s Domestic Fund Launches 1800

1474

1500 1200 900

300

678

571

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345 115

100

251

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1999

2000

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First half 2004

Initial subscription amounts of newly launched funds (RMB100 million) Source: Tianxiang Investment Systems

Sources and Uses of Renminbi and Foreign Exchange Funds Sources

Balance

Total Deposits Deposits of Enterprises Savings Deposits Trust Deposits Overseas Deposits Other Deposits Overseas Financing Purchase and Sale of Forex Interbank transactions (with non-residents) Other items

1,560 564 838 2 36 119 227 179.00 43 1,001

domestic funds is a proverbial drop in an ocean. Even so, it is an important pointer to the potential that exists for the growth and development of China’s nascent investment fund market. The insurance market is another case in point. Chinese insurers have long been frustrated by low investment yields largely because of tightly regulated investment channels. They are allowed to invest in bank deposits and bonds, but have to trade stocks only through securities investment funds. Largely due to the policy restrictions, insurers held 52% of their investments, totalling a combined RMB73.9bn (US$8.9bn) at the end of last year, in bank deposits, although interest rates are at a decade's low in China. The situation has improved somewhat in recent months as the government has reportedly approved in principal measure that allow insurance funds to set up asset management firms to manage indemnity funds; under limited conditions to invest in infrastructure projects and more importantly to use their foreign exchange assets to invest overseas – but only in bonds. Insurers will need to show they have a minimum of RMB5bn in total assets to apply for an overseas investment license.

Credit Funds of Financial Institutions Funds Uses Total Loans Short term loans Long & Medium Term loans Trust Loans On lending of funds raised overseas Paper financing Other Loans Portfolio Investment Interbank transactions (with non-residents)

Balance 1,346 491 502 12 174 14 154 1,088 574

As of September 2004 All figures in RMB100m (rounded up to nearest million) Source: People's Bank of China November 2004

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Special Report:

CHINA

Changes to MPF Index The Hong Kong Investment Funds Association (HKIFA) has announced the results of a ten month consultation programme covering the Hong Kong Mandatory Provident Fund (MPF). The results of the consultation are driving changes to the FTSE MPF series index, which take effect from the beginning of 2005. N EARLY FEBRUARY 2004, the Hong Kong Mandatory Provident Funds Authority (MPFA), the main pension provision for Hong Kong employees, with assets of $100bn, began a consultation programme to sound out the views of investors on disclosure for MPF investment funds. A draft Code provided guidance to approved trustees of MPF schemes and other service providers about the disclosure of information about MPF schemes and their constituent funds. In response to the feedback, HKIFA issued a new Code on Disclosure for MPF Investment Funds in June 2004 to MPF trustees and service provider that enhanced the transparency of fees and charges. It also began a further consultation with consultants Watson Wyatt and FTSE Group to review the Hong Kong MPF benchmarks for Equity and Lifestyle funds and gather up-to-date information from index users to ensure that the FTSE MPF Index Series, launched in 2001, provided the most precise benchmark for the market. Once the research responses were collated, the consultation reported that 78% of respondents would like the Total Return Index (TRI) to be based on MPF’s actual tax withholding rate and 75% of respondents want H shares to be included in the FTSE MPF Series.

A set of enhancements to the FTSE MPF series will now begin in January 2005 in response to the report. Changes include an alteration to the calculation of the total return indices, based on actual tax rates used by MPF funds. Three new indices will also be introduced, the FTSE MPF Greater China, FTSE MPF China and FTSE MPF Domestic Hong Kong indices “to better reflect the changing investment landscape,” says Graham Colbourne, director, FTSE Group.

Insurers and fund managers are set to cash in on Asia's private pension industry, which is expected to grow nearly four-fold in 10 years

H shares traded on the Hong Kong stock exchange will now be included in the calculation of the MPF Hong Kong benchmark and any individual constituents of the index will be capped at 10% of index weight. Further, exchanges that are not approved for MPF investment will now be excluded from all MPF Equity indices. The latest consultation does not affect MPF’s current bond indices, though these may be reviewed at

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some future date, adds Colbourne. The moves are timely. Insurers and fund managers are set to cash in on Asia's private pension industry, which is expected to grow nearly four-fold in 10 years as the world’s most populous region grows older. Pension assets held by insurers, fund managers and banks in Asia could potentially reach $13.4trn by 2015 from $3.8trn in 2002. Growth in the pensions sector depends on needed reforms that will spur long-term savings and remove restrictions on investments. Like other welfare systems around the world, Hong Kong’s MPF is facing the challenge of changing demographics – basically a longer-living, aged, nonworking population, a falling birth rate, and the drift of manufacturing jobs to lower wage countries with minimal labour, health and environmental protection. In Hong Kong around 11% of the population is 65 or above, a figure which is expected to increase sharply. Before the implementation of MPF in December 2000 only a third of Hong Kong’s population had retirement protection, now that figure is 84%. Changes are taking place throughout the region. China is reportedly planning to establish a voluntary pension scheme styled on the American 401-k plan called the Enterprise Annuity System. India and Singapore, meanwhile, are looking at low-cost privately managed pension schemes, while Taiwan and South Korea plan systems broadly similar to MPF.

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COVER STORY: STATE STREET

State Street Corporation has weathered the vagaries of the financial markets as well as any top performer, reporting 26 years of doubledigit percentage growth in operating earnings without hint of a hitch. But some analysts say that State Street hit a wall in 2003 and found that its dominance in the United States’ mutual fund market just wasn’t enough to sustain that level of growth over the next decade. Something would have to give. In early November 2004 State Street upped the ante and announced that over the next five years more than 50% of its revenues would come from overseas business. Can Boston’s finest achieve its goal? Francesca Carnevale went to Massachusetts to find out.

Ronald E. Logue, chairman and chief executive officer, State Street Bank

Bound OUTWARD

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Incorporated in 1970, State Street Corporation is one of ROM AN OUTSIDER’S point of view State Street Corporation (SSC) has always been the patrician’s the world’s biggest institutional asset managers, has two bank – high end, high value. Steeped in New England lines of business – investment management and investment tradition, State Street’s distinct style is a relaxed and services. That precise definition places State Street Bank seemingly effortless method, underpinned by careful firmly within a limited niche as unlike other specialist planning, hard salesmanship and drive. According to investment services providers (outside its investment recently appointed chairman and chief executive officer management operations) it has no other interests than (CEO) Ronald E. Logue, “State Street’s culture was serving the institutional investment community. Perhaps because of that focus, it inculcated into the bank dominates the highly as far back as the 1970s – State Street retains its dominance of the US mutual competitive US investment based on the force of fund market 200 services space, in which it personality of William 180 competes directly with Bank Edgerly who ran the 160 of New York, Citigroup, JP bank in the 1970s and 140 Morgan, Mellon Trust and 1980s. He created the 120 Northern Trust, among strategy of focusing on 100 others. Their business fee income, customers, 80 models are much more shareholders, employees 60 diversified however. Even so, and the community in 40 there is also much they have which we live.” in common. All have Typical of this developed a strong franchise approach is the way in State Street Corp. Northern Trust Bank of New York in the provision of which it established Data as at 30 November 2004. Source: FTSE Group investment services, they all State Street Associates LLC (SSA) back in 1999. SSA provides research into believe that non-US revenue is now more important than global asset allocation, equity trend research and currency ever before; all are aggressively expanding operations and management through a partnership of industry and personnel overseas (in particular in Europe and the Far academia. The group was spearheaded in the bank by East) and all are facing a tougher, more competitive future. At the apex of SSC’s thinking and market strategy is now Stan Shelton, executive vice president of the bank’s Global Markets group (the bank’s investment research Ronald Logue, who was appointed steersman in late June and trading arm) and Mark Snyder, executive vice this year, following the retirement of David Spina. During president of its money market trading and sales activities, his four-year tenure as CEO, Spina honed the company’s who is also chairman of the New York Federal Reserve focus on serving the needs of institutional investors Bank’s Foreign Exchange Committee. “We purposely through divestitures of its corporate trust and private asset located SSA outside our downtown Boston head office, management businesses as well as some notable acquisitions, which settled explains Snyder, “we put the bank’s dominance in them in surroundings in Without question 2003 was decisive for custody services. Assets Cambridge which are State Street. The bank had dramatically under custody grew by conducive to creative thinking – unshackled from altered its business in recent years, shifting $3.2trn to $9.4trn and assets under management crossed the day-to-day commercial away from higher-profile investment the $1trn mark. imperatives of our trading management toward custodianship. Spina officially retired for environment. It has been a health reasons in the early very fruitful enterprise, intellectual thinking married with market strategists and summer, though some analysts question why it had higher bandwidth sales traders.” Informally, Snyder happened so suddenly. Certainly the SSC board had appeared extraordinarily well prepared for his departure explains, they call it “capuccino thinking”. “Only in a place such as Boston could this happen, and it progressed quickly and smoothly. Logue had joined the bank back in 1990 as senior vice perhaps,”smiles Snyder,“but while there is an aesthetic and cerebral feel to SSA, there is a serious commercial president and head of investment services for US mutual underlying purpose. SSA provides the research backbone to funds. He rose to chief operating officer in 2000 and the three key ingredients in delivering value to our Global president and vice chairman a year later. As president, he Markets customers – the others being technology and was responsible for overseeing State Street’s investment liquidity and trading services. State Street Global Markets’ services, securities finance, investment research and research offerings rely on SSA’s analysis of a robust trading activities, as well as information technology. With database, capturing 15% of the world’s tradable securities, that range of experience he was a natural choice to succeed Spina. Logue himself puts it down to a strong client focus equivalent to 80% of total global institutional decisions.” Au

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COVER STORY: STATE STREET

Ed O’Brien, executive vice president and head of State Street's securities finance/lending business

and an “ability to execute consistently well. I have done many of the jobs around here, which puts me in a good position as the face of State Street.”Directness and handson experience means that it is unlikely that morale will suffer on Logue’s watch. “First priority, I’m out in the market, where I need to be. Then I have to be out there walking the floor,”says Logue pointing to the trading room visible through the glass wall of his temporary office. According to Gerard Cassidy, banking analyst at Royal Bank of Canada (RBC), Logue’s style “will be meaningfully different for investors as well. He is direct and will help communications with shareholders and analysts. We certainly expect more clarity on strategy.” That clarity came in early November, with a seminal declaration to investors and analysts that over the coming years State Street would harvest more than 50% of its future revenues from overseas. Today, non-US revenue accounts form around 35% of the bank’s total earnings – to uptick that to over 50% will test the bank in more ways than one. According to RBC’s Cassidy, “the bank’s competitive advantage – dominance in mutual funds – is not available in non-US markets. This is a race to garner as much market share as possible.” In doing so, it will change the face of State Street forever. Cassidy agrees. “In the US market, State Street, like other big institutional banks, has been a harvester. In the international markets however they perforce change their nature and become hunters instead.” According to Jay Hooley, executive vice president and head of investor services the reality is far less rustic.“There

is a structural change underway, which has been visible for some time. Non-US revenues are growing at twice the rate of US revenues. At the broadest level there is $9.4trn in available assets in pension and mutual fund pools in Europe and 92% of those assets sit in six different countries. We have a significant infrastructure in place, providing local services and addressing local concerns. We have 4100 staff alone in Europe.” The commitment to internationalism is a natural extension of State’s Street’s experience of the last three years. Partly, it is in response to a domestic market that has changed irrevocably. Investment managers forgot about processing operations as they reaped the harvest of a decade long equity bull market. But with margins under pressure for a prolongued period and the aftermath of Sarbanes Oxley, everyone began to worry about the state of their back and middle offices. For custodians, such as State Street, it came as both good and bad news. Outsourcing became an important new source of revenue, but investment managers also became more demanding about services and began to push back on spend. As well, business growth rates at home were slowing and opportunity began to beckon elsewhere. “Don’t think it’s just a US phenomenon,” says Ed O’Brien, executive vice president and head of State Street's securities finance/lending business, “the average European pension fund is market literate and understands clearly value for cost, revenue versus expenditure. This is grist to our mill. Our best, most exciting relationships are where we get into specialist situations.” Even so, without question 2003 was decisive for State Street. The bank had dramatically altered its business in recent years, shifting away from higher-profile investment management toward custodianship. That trend had quickened following the acquisition back in 1999 of Wachovia Trust’s master trust and institutional custody businesses, representing approximately 270 client relationships with about $61bn in assets. That deal increased State Street’s middle market (that is, accounts with less than $500m in assets) share as well as augmenting its presence in the American Southeast. Growing in confidence State Street began looking for bigger fish to fry. Just how true that was came to the fore in late 2002/early 2003, as Spina and Logue walked away with one of the custody market’s greatest prizes. State Street bought Deutsche Bank’s Global Securities Services business. The deal was the largest acquisition in the corporation’s history and one that completely transformed the bank.The sale had come about in a package of cost-cutting efforts at Deutsche Bank and at a time when State Street needed a decisive move as slowing fee revenue in the US bear market of 2001/2003 began to bite. State Street made an initial payment to Deutsche Bank of approximately $1.1bn for the business. Although under separate closing agreements, covering business units in Italy and Austria, the bank reportedly paid the Germans a further $360m. The strategic benefits of the buy were obvious, including a broadened global client base, leadership in the high-

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growth European market and considerable economies of scale. More importantly, the deal catapulted State Street way past Citibank, Bank of New York and JPMorgan Chase as the world’s largest institutional record keeper and added some $2.2trn of assets to the $5.7trn that was under State Street trusteeship. But the deal meant more, much more. Not since 1999, when Royal Bank of Scotland sold its custody operations to Bank of New York and Deutsche Bank itself merged with Bankers Trust, had there been a notable exit from the global custody business. An exit from the mighty Deutsche Bank was in itself significant. In the custody arena it was altogether a bigger affair. Deutsche Bank had been Europe's biggest global custodian and the fourth largest player in the world. Everyone wanted Deutsche Bank’s business, though the general consensus was that the Germans would sell out to HSBC or BNP Paribas rather than any of the other big hitters in the custody arena. “It was our best opportunity in Europe,” explains Logue. The bank had purchased much more than big-number assets under management. “It gave us name recognition and critical mass in a market that is fragmented. It meant that we could offer clients a one stop shop.” Within this context, the strategy for expanding overseas business is replete with imperatives.

Additionally, maintains Logue, to help the bank on its way. “One of the greatest hidden assets in the sale were 60-70 middle managers, non-US passport holders, who could populate important positions within the bank and bring a different perspective and understanding of our clients wherever they are in the world…we’re bringing non-US passport holders to work over here and make contacts and teach Americans, where appropriate, how things can be done.” State Street took on over 3,000 Deutsche Bank personnel, though the integration did mean that 1,000 personnel would have to go, mainly in the US. At the moment of its greatest success, ironically, the bank was also beginning to face some testing challenges. While the integration of Deutsche Bank’s staff and systems was, in the main, fast and successfully implemented – other glitches began to impinge on the so far impeccable performance of the bank. A new corporate building in Boston had been commissioned in 2000, which by 2003 began to look overly expensive, particularly given the slowdown in downtown realty prices and the upturn in empty Massachusetts office space. Early in the same year, the bank announced a voluntary retirement package, following the acquisition of

Top Institutional Shareholders in State Street Corporation 76% of shares in State Street Corporation are owned by Institutional & Mutual Fund owners Holder Shares % Out Reported State Street Corporation 15,925,879 4.74 30-Jun-04 Putnam Investment Management, LLC 15,145,966 4.50 30-Jun-04 Barclays Bank Plc 10,949,122 3.26 30-Jun-04 General Electric Company 10,780,951 3.21 30-Jun-04 Northern Trust Corporation 9,788,732 2.91 30-Jun-04 Price (T.Rowe) Associates 8,633,006 2.57 30-Jun-04 Vanguard Group Inc. 6,829,599 2.03 30-Jun-04 Wellington Management Company, Llp 6,769,149 2.01 30-Jun-04 Jennison Associates LLC 6,675,455 1.99 30-Jun-04 Citigroup Inc 5,897,721 1.75 30-Jun-04

Value* (US dollars) $781,005,096.00 $742,758,163.00 $536,944,936.00 $528,697,830.00 $480,529,811.00 $423,362,608.00 $334,932,530.00 $331,959,062.00 $327,364,309.00 $289,224,423.00

Top Mutual Fund Shareholders in State Street Corporation Holder Vanguard 500 Index Fund Putnam Fund For Growth and Income Price (T.Rowe) Blue Chip Growth Fund Inc. Price (T.Rowe) Growth Stock Fund Inc. Davis New York Venture Fund The Jensen Portfolio College Retirement Equities Fund-Stock Account Hartford Advisors His Fund Inc. Harbor Capital Appreciation Fund Pioneer Fund

Shares 3,121,926 2,780,500 2,320,000 2,049,000 1,997,500 1,996,000 1,685,393 1,669,000 1,657,500 1,613,600

% Out 0.93 0.83 0.69 0.61 0.59 0.59 0.50 0.50 0.49 0.48

Reported 30-Jun-04 30-Apr-04 30-Jun-04 30-Jun-04 31-Jan-04 30-Jun-04 31-Dec-03 30-Jun-04 30-Apr-04 30-Jun-04

$153,099,249.00 $135,688,400.00 $113,772,798.00 $100,482,958.00 $107,565,375.00 $97,883,838.00 $87,775,765.00 $81,847,758.00 $80,886,000.00 $79,130,943.00

Source: Yahoo Finance/Reuters/Hoovers Online * Value shown is the computed result using the price of the security on the report date given

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Deutsche Bank’s custody business and had expected a take-up in the region of 1,000 personnel. Instead some 3,000 employees reportedly took up the offer and immediately whacked State Street’s strong self-belief in the contentedness of its staff. It was bad for morale (and expensive) as the bank had to go out and hire new people, many at high level. The cost wasn’t just in money. In some instances the bank lost valuable processing expertise. Logue is typically upfront; “Frankly the voluntary redundancy was a good opportunity for some people to take, but when you adopt a policy like that, you lose control. You can say what you want about it, but in my opinion if we had done it on an involuntary basis, it would have been much worse. It goes back to the nature of the company. This company values employees – involuntary redundancy is not the way we like to do things.”Additional expenses also racked up on the processing side as training requirements for incoming staff pushed up costs further. Armed with a comprehensive strategy and assets, State Street is a bank in transition. “I see three key tasks ahead, to look hard at expenses in a slow growth environment; clearly communicate our goals to the global market and internally clearly express my expectations of the business,” says Logue. “Invariably we have to put more focus on market driven revenue.” The challenges that State Street will face in implementing a foreign focused strategy brought it to the attention of the ratings agencies. Fitch Ratings was the first to draw blood, lowering the Corporation’s long term rating and that of its primary operating subsidiary State Street Bank and Trust Company from AA to AA-, and affecting some $2.4bn of long term debt. According to David Spring, senior director, financial institutions, at Fitch Ratings, “The downgrade reflects that State Street's recent pattern of earnings volatility. Nonetheless, State Street remains a quality franchise with relatively low risk.This action will align State Street's ratings with those of other large, diversified U.S. processing banks. Spring cites the scaling back of growth plans in the wealth management business and the planned exit from State Street’s interests in wealth management specialist Bel Air Investment Advisors (which it acquired at a premium in early 2001), will be exited in early 2005, resulting in a significant charge to earnings (around $150m to $170m). Logue is sanguine, citing the disbursements as necessary to ensure State Street is less vulnerable to market swings. “Things change. It no longer tallies or fits with the products we sell to institutional investors. I think it is important to face up to issues as environments change. I do not know if the market expects that approach, but that is who I am.” Logue, in an interview in early November with Reuters, described third-quarter conditions as the worst he has seen: third quarter profit fell 12% amid lower revenue and higher expenses, including a 26% drop in foreign exchange trading revenue and a 21 % decline in securities lending fees, which outweighed higher revenue from management fees. Thirdquarter net income, including $16m in merger and

Jay Hooley, executive vice president and head of investor services

integration costs, dropped to $177m, or 52 cents per diluted share, from $202m, or 60 cents, a year earlier. Total operating revenue rose to $1.2bn from $1.1bn in the year-earlier quarter but was down from $1.bn in the 2004 second quarter. Operating expenses jumped 14 % from a year earlier to $890m, fuelled in part by higher salaries and employee benefits, but were down 5% from the second quarter. Reports also say that the bank will lay off 2% of its work force, cutting 425 jobs, as part of a reorganization designed to save $50m. One swallow doesn’t make a summer and a bad quarter’s result does not presage anything other than a temporary blip says Ed O’Brien. External events remain a challenge, admits Logue. “I do not think we are going back to the days of the 1990s. There will be slower growth for some time to come, hence the need to focus on expenses.” Focus is everything, maintains Jay Hooley. “That is our strategic advantage. It is easily said, but it takes a significant commitment of long term resources to be where we are in the business. That business is described by pension funds, mutual funds and insurance companies. In Asia, perhaps the mix is a little different, because of the evolution of assets in central banks and in that region they are a big segment for us.” “That’s right,”concurs RBC’s Cassidy.“Although the bank is in transition, the outlook for the sector in which they dominate is positive. In the short term, the market will be looking to see if Logue is disciplined and can handle the challenge. The initial read is that he is. His clock starts running on Jan 1 2005. That is the year when both Logue and the bank will have to show results for the initiatives now in place.”

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CEMEX

Reinforced

bridging strategies EMEX’S IMPENDING PURCHASE of British construction supplies and services company RMC makes it the biggest ready mix cement company in the world. It remains the world’s third biggest cement producer but is now breathing down the neck of the second, Swiss company Holcim. The acquisition is probably the largest transatlantic purchase since the markets plummeted in 2001 – and certainly the biggest ever for a Mexican company, and makes the company a truly global player in a product that is essential as it is unglamorous. It has lots of seminal lessons to teach G8 competitors about global management, acquisitions and finance. The acquisition of RMC will give CEMEX a wide European presence, dovetailing into existing Spanish operations. The British company’s holdings in the United States (US) also

C There has been a lot of talk about how globalization impacts on emerging markets – but CEMEX, the Mexican cement and concrete giant, has turned the terms of trade around, emerging from the developing world onto the global markets – with concrete results. Ian Williams reports on CEMEX’s impending purchase of the UK’s RMC Group, one of Europe’s top six cement producers.

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CEMEX Reproduced with the knid permission of CEMEX

“Immediately upon completion of this transaction, the blended cost of debt in CEMEX will actually go down, by more than a hundred basis points, which should have an immediate impact on our weighted average cost of capital.”

make an almost seamless match with CEMEX’s previous acquisition of Southdown four years ago. Marking the end of independent ownership for what was then the largest US based cement company, Houston-based Southdown sold all it outstanding stock to CEMEX at $73 per share (at a 30% premium to its then share price), equivalent to around $2.8bn, including $185m in long-term debt. That deal gave CEMEX the status of cement powerhouse, accruing than $6.3bn in annual sales. And until the RMC Group deal, it had been CEMEX's largest acquisition. Different times, different strategies. CEMEX’s acquisition then was among the most notable of a range of deals in the late 1990s as foreign owned construction giants made a land grab among US companies to leverage an expected jump in infrastructure projects resulting from the 1999 Transportation Equity Act (the TEA-21 bill) passing Congress. Southdown's primary markets – California, Texas, and Florida, in particular – were expected to benefit considerably from TEA-21 expenditures. On the same day the Southdown deal was announced, CEMEX issued a statement stating that its board of directors had approved a

share repurchase program worth $500m (equivalent to then just under 8% of CEMEX’s market capitalisation) over a 15 month period up to the end of 2001, funded by the company’s repurchase reserve. In the RMC Group deal, CEMEX is paying $4.15bn in cash, in addition to assuming RMC’s debt. They raised the overall $5.8bn cash at less than LIBOR +1, a rate so low that Maher Al Haffar, managing director, corporate finance at CEMEX, and formerly a banker himself, exultantly points out “Immediately upon completion of this transaction, the blended cost of debt in CEMEX will actually go down, by more than a hundred basis points, which should have an immediate impact on our weighted average cost of capital.” Not surprisingly, Haffar sees it as massive vote of confidence in the company by the bankers – and he points out that CEMEX’s trailing twelve month free cash flow of $1.4bn was enough to win them over, even before the expected benefits of RMC’s own operations were factored in to the analysis. The financing will be over half in dollars, with the balance split between Euros and Sterling, which also reflects the expected cash returns from RMC’s various operations, offering a built in hedge on currency movements. The sources of the finance, diversified among the company’s various subsidiaries in Europe and Mexico, taking advantage of good conditions in the home base, hint at CEMEX’s globalised financial sophistication – part of which is centralised cash flow management that allows it to use its full fiscal weight. However, CEMEX is not averse to dispensing with some existing assets to pay for new ones. In mid November, CEMEX announced it had signed a Letter of Intent with Brazil’s Votorantim Cimentos LTDA for the sale of selected CEMEX assets in the US Great Lakes region, worth around $400m. According to the company’s official statement on the sale, CEMEX began evaluating alternatives to divest these assets at the beginning of 2004, after reviewing “its strategic position in the US”. The transaction is expected to close in the first quarter of 2005 and monies used to either pay down debt or reduce the level of indebtedness required for the RMC acquisition. “With the acquisition of RMC, the new CEMEX will be more integrated across the value chain, with the scale and reach that we need to compete effectively and profitably in the years ahead. With this acquisition, I am confident that we will continue to produce the kinds of results that our shareholders have come to expect from CEMEX,”says chief executive officer (CEO) Lorenzo H. Zambrano. His constant partner in CEMEX’s global expansion, chief financial officer Rodrigo Trevino added,“Our priority will be to use free cash flow generation to pay down debt, until we reach our desired capital structure. We expect to reach a net debt of 2.7 times our EBITDA by the end of 2005. This would be the same level we had at the beginning of 2004.” It was also the level that some shareholders had actually pushed for as more appropriate than the low pre-purchase level.

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De c-9 9 Ap r-0 0 Au g00 De c-0 0 Ap r-0 1 Au g01 De c-0 1 Ap r-0 2 Au g02 De c-0 2 Ap r-0 3 Au g03 De c-0 3 Ap r-0 4 Au g0 No 4 v04

institutions have almost Some US analysts A buoyant outlook for the construction and building sector doubled their position in questioned the 40% 140 CEMEX in the past three premium that purchase 130 years, while retail investors put on RMC stock, but Al120 in the US have almost Haffar claims that the 110 tripled their interest. premium was a win-win 100 CEMEX has indeed situation, especially when 90 come a long way since the compared with the 80 century old Monterey outcomes of the disputed 70 cement company went Lafarge takeover of Blue 60 public as in 1978. Circle. “We wanted to pay Zambrano, grandson of a fair price to the RMC FTSE All-World – Construction & Building Materials Cemex Sa Cpo Line the founder, put fizz in the shareholders, because we dull grey powder and has wanted the transaction to Data as at 30th November 2004. Source: FTSE Group been innovating ever happen promptly, and since. The company peacefully. From our perspective, that means that employees and customers are bought Tolteca from Blue Circle ten years later consolidating its position in Mexico, and has been going to feel uncertain for a shorter period of time.” Market share, morale and the whole corporate cementing its way across the Rio Grande ever since. Then momentum can get lost during a protracted and contested came the Southdown acquisition. Far from acquiring American technology, they brought in takeover, he concludes. And, cannily, to discourage spoiler bids, CEMEX acquired 18.8% of RMC stock the same day CEMEX IT and managerial skills to a relatively inefficiently the buyout was announced. Trevino also justifies the run business, where each plant handled its own premium,“Since 1998 our return on capital employed has procurement, and even down time without coordination. been consistently above ten percent, and we expect that the CEMEX has pioneered putting silicon into delivering RMC acquisition will offer returns of 10% once the merger silicates. It set up its own satellite communications network integration benefits are realised. We expect this to happen and pioneered the use of computerisation to ensure ‘Just In by 2007.” Al-Haffar emphasises that “The $200m of Time’ delivery of its products – crucial when dealing with synergies we talk about from the deal are based on tons of concrete trying to set hard! To the many of us who are not completely au fait with the benchmarking the RMC businesses and geographies at the cement business, it is worth remembering that producing lower end of the range of our productivity metrics.” Despite a determined effort over the last few years to the actual cement is not necessarily done by the people who woo the equity markets, as shown by the effort to keep deliver tons of wet concrete to the site of your new office. shareholders informed and happy with the transaction, The CEMEX/RMC deal integrates two companies with CEMEX still scorned to use equity for the purchase. They different centres of gravity in the two business sectors. considered that it would have made no sense at all with CEMEX sees big prospects in the vertical integration that such low interest rates, and would have prolonged the comes from owning the process from quarry to building site. Al-Haffar points out that in the US, while CEMEX speedy consummation of the deal that CEMEX wanted. In addition, management still feels that its stock is currently sends only 12% of its cement through its own undervalued, as metropolitan investors still wrestle with the idea that a stake in CEMEX is no longer a risky play on emerging markets, but a logical stake in the global economy. Indeed, the company has also been engaged in a parallel shareholder education drive to persuade investors that cement is not as cyclical as the other materials on the world market such as copper and aluminum that have significant troughs and peaks within the cycle. The key countercyclical element is, they point out, the amount of cement poured into infrastructure – which always goes up in election years, and is often the target of Keynesian spending during recessions. Although it is already now becoming the US’s largest cement and concrete maker American investors have still not quite naturalised CEMEX but they have been catching up quickly in the face of management’s blandishments. Even before the deal, liquidity was higher in the ADR than in the home market, the Mexican Bolsa. US Reproduced with the knid permission of CEMEX

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CEMEX, while supporting ready mix channel, the Reproduced with the that in principle, does not combined operation brings knid permission of at present seem convinced that up to more than 30%. CEMEX that this necessarily means The other aspect where listings in London or CEMEX has great Frankfurt. Al-Haffar thinks expectation of reaping that eager investors will go much bigger benefits is “If we build a plant to Mexico or New York – their distinctive managerial in China, and we have and indeed notes with mix of closely centrally to borrow the money on pleasure the increase in integrated financial and the international capital liquidity on the NYSE production planning with where the average daily considerable local initiatives market, we may not have trading volume has almost in branding and marketing. the advantages of some doubled since the RMC CEMEX management of the local capitalists who deal was announced. “At look at RMC’s may have substantially the end of the day,” he decentralised structure as more advantageous concludes, “investors are an opportunity for big terms locally” reasonable enough, savings not least based on flexible enough, and their experience from intelligent enough to go to coping with Southdown the market that has the which they describe as “invaluable”. It was not only the assimilation of a highest amount of liquidity.” While RMC has mostly worked in mature economies, company that was decentralised, it led to an appreciation of the size and diversity of the US markets where the CEMEX is confident that its own distinctive management Texan and Californian economies are not only as big as style will pay dividends, for example in RMC’s German many separate countries, but are almost as different in operations which currently have a somewhat lack lustre performance. And having missed out on the initial wave of their cement demands. “The centralisation and standardisation process that we privatizations in Eastern Europe, they are happy to move in put into place over the last four years was a very, very good just as European Union accession puts some zest in the preparatory work for this larger, multinational transaction,” construction industry there. With all these expansion plans, there is a dog that you says Al-Haffar. “It translates to higher returns on capital employed, do not hear barking. Where is CEMEX in India and China, because of global procurement. You don’t necessarily save two markets that consume cement as if it were rice, and money because you have fewer people and more both set to grow even further? They have indeed computers. You save money because you’re able to get considered it – and they do sell cement to China. economies of scale. You get a much faster knowledge- CEMEX’s vaulting ambition depends on a secure pole sharing process, a much faster best-practices transfer, and before taking any great leaps forward, and management is you are able to frankly negotiate better terms with your sensible of the somewhat eccentric financial structures service and product providers when you’re doing that, that would face a foreign owned start up in competition with local Chinese players. “If we build a plant in China, particularly in energy.” One reason for decentralised operations by and we have to borrow the money on the international multinationals is the familiar Tower of Babel syndrome. capital market, we may not have the advantages of some Like similar companies, CEMEX has overcome fissiparous of the local capitalists who may have substantially more tendencies by adopting English as its international advantageous terms locally”smiles Al-Haffar,“so we think operating language – even though, as befits a proud we need some time to get the capital allocation process Mexican company, all head office communications are dual more rational in China.” Quite apart from that, with the huge size of the two language, in Spanish and English. Of course local operations are conducted in the market and the huge amounts of capital involved, even the appropriate national languages, which is just as well for a ambitious and voracious CEMEX will want time to digest company with existing operations from Indonesia and the its current acquisition before trying at these opportunities. Philippines to Spain and Egypt, that is now going to add One essential quality for mixing in the global cement market is to have a hugely holistic view of the dynamics of the EU and Eastern European operations with RMC. One remedy for the perceived undervaluation of CEMEX the global economy. It already has big operations in stock would be to consider attracting shareholders from the Indonesia and the Philippines from which it can keep a new regions of operation, in particular, Europe. After all close eye on Asian opportunities so there is no rush. there are all those happy investors in RMC who may want CEMEX will be watching and waiting to make someone in to continue setting their money in cement. However, Asia an offer they can’t refuse.

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FUND PROFILE

F RR

to the rescue

France’s recently created Fonds de Réserve pour les Retraites (FRR) has a vital role in helping to secure the country’s state-funded pension system. The fund is now leading France’s most important cavalry charge. Paul Whitfield reports from Paris.

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HE LOOMING SHORTFALL in the French statefunded pension system is a challenge with an inevitable long-term solution. The scheme, like many of Europe’s state pension schemes, is financed on a pay-asyou-go (PAYG) basis, whereby the current working population pays for the pensions of those who have retired. Until recently this worked because there had been a lot more workers than pensioners; the contributor to pension ratio is currently a little over two. That ratio is deteriorating, as birth rates fall, as retirees live longer and, most immediately, as the baby-boomers of the 1960s reach

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retirement. The figures are sufficiently large to give serious knocked out of the process at an early stage – of the 410 pause for thought. During 2003 France had an estimated applications 137 made it to the second stage of 500,000 new pensioners. That figure will rise to 800,000 by deliberations. Chief amongst the complaints was the size 2005. French government projections suggest that the ratio of the initial screening document, an exhaustive of workers to pensioners will drop to 1.2 – 1.3 by 2040. They questionnaire, described by one fund manager as both also suggest that by 2020 the French pension system will be “impressive”and “ridiculously meticulous.” The manager selection committee was chaired by de running a deficit of €11bn rising to €37bn by 2040. Faced with a potentially ruinous scenario the then Salins, a graduate of France’s elite political/management government of Lionel Jospin proposed, as part of the social school, Ecole Nationale d’Administration, a former advisor to the director of the security financing act of French Treasury and a November 1998, to launch a French representative to the reserve fund to shore-up the European Union. Antoine de nation’s pension funding. It is not just institutional investors that Salins admits that the The move was laudable, yet will be scrutinising FRR. Inevitably, the questionnaire was thorough had just a hint of concern in fund will be watched with interest by but makes no apologies.“We its rapid development. It was other European governments, particularly wanted to build a also a brave move. The Italy, Germany and Austria who face partnership for the long memory of 1995, a year in term so we chose managers which the then French prime a similar PAYG pension crisis. who were able to help us minister, Alain Juppé, lost his understand exactly how they job as he tried to force functioned. This is the through pension reform, was reason our questionnaires were so detailed. It meant that still fresh in the minds of many. Jospin’s notion was to build a reserve fund, using state offers that were not very clear or which poorly explained capital injections, for 20 years, until 2020, at which time the their answers to our questions were penalised in the accrued pot of assets would begin to pay money into the selection process.” “We had three very traditional selection criteria that state-pension system, easing the burden of paying for the growing numbers of retirees. That fund came into were, in decreasing order of importance: the quality of the existence, albeit as part of the Fonds de Solidarité Vieillesse investment process and the management team; the quality (FSV), in 1999. Two years later, in July 2001, it became a of the organisation’s middle and back office; and the price. We stayed true to that order of importance throughout the standalone entity and the FRR was born. The construction of the reserve fund was a unique test. decision making process.” After eight months of deliberation the board announced Antoine de Salins, a member of the executive board of the fund and chairman of the manager selection its choice of 11 asset managers for €10bn of mandates. The committee, says: “There were four distinct challenges. We announcement was accompanied by another round of had to put in place an effective organisation. That meant (largely anonymous) sniping. Fund managers claimed that finding people who were competent and motivated by fees for the work were too low to be profitable (though no this special project. We had to define an investment manager turned down the offer of a mandate) and, strategy that was acceptable to our board of trustees and depending on who you listened to, that the process had which had risk-return goals that the board was been skewed to favour French or non-French managers. In comfortable with. We had to conduct an enormous the end, the list of mandate winners held few surprises, international tender for managers and to assess and leading one (unsuccessful) French manager to describe it select excellent managers in a way that was both as “a roll call of the usual suspects”. Barclays Global Investors and Vanguard Investments professional and transparent and, importantly, in a way that was seen by the industry to be both of those things. Europe both won €1bn passive large cap euro zone equity Finally we had to make the sort of innovative technical mandates, while Vanguard also picked up a €640m passive choices that you can see in the way we constructed our large cap US equity. Crédit Lyonnais Asset Management meanwhile won €1.2bn of active and passive equity funds, fund and in the characteristics of our mandates.” FRR began its investment operations in the second and Axa Investment Managers Paris won a €960m euroquarter of 2004, following a legendarily-exhausting denominated bond mandate and a €200m active small and management selection process. The initial public call for mid cap equity mandate. Robeco Institutional Asset tenders, in July 2003, elicited 410 applications. The scale of Management and HSBC were given €960m active the response surprised most people, including the fund government and corporate bond mandates, while CDS IXIS itself which, in June of that year, had predicted it would and AGF Asset Management both won €960m four-year fixed income mandates. The majority of the mandates receive about 100 applications. The selection process attracted its share of criticism, not tendered by FRR are actively managed, reflecting the fund’s the least from fund managers who found themselves belief that active management delivers superior performance.

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Antoine de Salins, member of the executive board of FRR and chairman of its manager selection committee.

The attractions of working with FRR, and the reasons for the acrimonious disappointment amongst fund managers that weren’t selected, are no mystery. The project is exciting, undeniably ambitious and, perhaps most importantly, enormously wealthy. At launch FRR had some €16.6bn under management. It is expected to have grown to more than €23bn by the end of 2005 and will be closer to €130bn by 2020, putting it on par with Europe’s biggest pension funds. No matter its size, the reserve fund will not be (nor is it meant to be) a fix-all for the French pension system. The fund’s first annual report emphasised it transitory role as a “smoothing mechanism” designed to give the government time to institute necessary reform and to ease the burden of today’s profligate pension system on future generations. The concept behind FRR is innovative if not exactly revolutionary. Norway established a reserve fund (though one with a broader economic remit) in 1990. And at the same time as the French proposal was being passed into law the Irish passed the National Pensions Reserve Fund

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

Act, establishing a platform for the construction of the Irish National Pension Reserve Fund (NPRF). FRR is however the first fund of its kind to be set up specifically to ameliorate the effects of an ageing population. Initial capital for the fund came from a range of sources, not the least of which was the proceeds of the sale of France’s third-generation mobile phone licences and state industries, which contributed some €6bn. A little over €4bn came from the French governments 2% social tax, €4.5bn was taken from the French National Old Age Fund (the Caisse Nationale d’Assurance Vieillesse) with the rest arriving from “miscellaneous sources”. The one-off nature of much of this funding has raised questions. The decision not to ring-fence a taxproponent of contributions for the fund, as the Irish did, has left some experts questioning the reliability of future funding and thus future projections of the fund’s value. The decision clearly leaves the fund somewhat at the mercy of political whimsy – though so far it has been well supported by both its founding centre-left and current centre-right governments. Much about the fund is undeniably political – both in conception and ongoing influences. Its supervisory board, which plays the role of trustees, is made up of politicians, civil servants and the ambiguously named “social partners” (largely unions and employer groups). The board doesn’t intervene in management decisions but has considerable power given that it must approve both the allocation strategy and the accounts. Supposing the political support, and funding, continue there is little to suggest that FRR won’t hit its investment goals. Indeed the fund has some key investment strengths that would make it the envy of many pension funds. De Salins says: “The investment horizon for a reserve fund is much longer than for a typical pension fund because reserve funds do not have the immediate constraint of short-term liabilities. We can act as a longterm investor and don’t have to react to short term market movements, indeed it is clearly understood by our board that there is no short-term stop-loss as we pursue our longer term aims.” FRR also stands to benefit from its cautious annual real-return target of 4%; a target that de Salins admits is based on generously-conservative macro-economic estimates. The risk-averse nature of the target is

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FUND PROFILE

Forays in to these asset classes put the fund at the reflected in the FRR’s asset allocation. Some 38% of the fund is invested in Eurozone bonds, of which 10% is forefront of current investment fashion. Innovation is allocated to corporate bonds. Another 7% of the fund is something the FRR has never shied from. It was one of the invested in international bonds, with nearly half of that first funds to ask third parties, FTSE and Iboxx Euro, to allocation allocated to corporate bonds. Given the FRR’s provide benchmarks, rather than accept those supplied by unusually long investment horizon (with no pay-outs asset managers. It developed a proprietary in-house performance monitoring made prior to 2020), its platform and is planning, bond allocation of 45%, next year, to augment it with with more than one-third in The fund is currently looking at adding additional hire of an government bonds, is external performance unlikely to elicit charges of private-equity (through fund of funds) monitoring service. reckless risk taking. and socially responsible investment De Salin is conscious that The remaining 55% of the mandates to its portfolio. In October the fund is a natural leader fund is allocated to equities, 2004 FRR’s CIO Jean-Louis Nakamura but is cautious of adding this with 38% invested in indicated that the fund would tender role to its already weighty eurozone shares and 17% in mandates worth “several hundred million responsibilities. He says: “It is international markets. true that as a result of its role, According to de Salins: euros” for both asset classes. its public status, its size and “FRR defined its asset the innovations it has put in allocation strategy with place, the FRR has aroused regard to its (long) investment horizon, its risk profile and some other the interest of the local and international financial constraints, in particular its exposure to exchange rate risk community. Such recognition is an honour and naturally our (a maximum 20% in non-euro investments). Our strategy objective is to be regarded as a professional institutional and our structure will evolve over time: other asset classes investor reference in Europe, but it is also necessary to remain modest: we have many things still to do and to learn.” will be added gradually.” It is not just institutional investors that will be The fund is currently looking at adding private-equity (through fund of funds) and socially responsible scrutinising FRR. Inevitably, the fund will be watched with investment mandates to its portfolio. In October 2004 interest by other European governments, particularly Italy, FRR’s CIO Jean-Louis Nakamura indicated that the fund Germany and Austria who face a similar PAYG pension would tender mandates worth “several hundred million crisis.Yet, as a test case, FRR has limited value; by the time euros” for both asset classes. The tenders will be issued in the fund’s success, or failure, can be assessed the February with the aim of hiring managers by the end of the opportunity for other countries to copy the model will have first half of 2005. The FRR board is currently studying the long passed. Ironically, by the time France knows whether SRI policies of a number of Nordic funds and has tentative the fund has succeeded the same will apply to its pension plans to meet with their counterparts to discuss policies as system. In the intervening years the focus will be on FRR. As with any cavalier, it is expected to come to the rescue. it formulates its policies.

FRR 2003 Mandates Asset Class Index Lot 1 – Eurozone large caps, passive management FTSE Eurozone Large Cap Index Lot 2 – Eurozone small and mid caps, active management FTSE Eurozone Mid & Small Cap Index Lot 3 – Eurozone large caps, active management FTSE Eurozone Large Cap Index Lot 4 – US large caps, passive management FTSE US Large Cap Index Lot 5 – US mid caps, active management FTSE US Mid Cap Index Lot 6 – US large caps, active value management style FTSE US Value Large Cap Index Lot 7 – US large caps, active growth management style FTSE US Growth Large Cap Index Lot 8 – Europe ex-eurozone large caps, active management FTSE Developed Europe ex-Eurozone Index Lot 9 – Pacific Rim large caps, active management FTSE Developed Asia Pacific Large Cap Index Lot 10 – Eurozone bonds, sovereign and credit, active management iBOXX Composite Euro Indices Lot 11 – International bonds indexed to inflation, active management Composite Inflation-Linked Bonds Index Barclays Capital Lot 12 – International bonds ex-eurozone, active management Global Aggregate Index Lehman Brothers

Tracking Error 0.5% 10% 5% 0.5% 8% 7% 10% 5% 8% 2% 1.5% 2%

Source: FRR 2003 Annual Report

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flexes muscle at home and abroad

HE LEXICON OF modern American retailing history reads like an over-ripe scifi noveletta. Through the 1990s, America’s one-stop shopping compulsion scaled new heights with the advent of the ‘power centre’. This was a massive collection of retail outlets anchored by the so-called “category killer” – a large national chain establishment whose overwhelmingly diverse line of products either threatened or destroyed smaller businesses that stood in its path. Typically located on the outskirts of a regional shopping

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SECTOR PROFILE: WAL-MART

Wal-Mart

Global expansion is a top priority for Wal-Mart, which began to solidify its non-domestic base a decade ago with the formation of Wal-Mart International, currently led by chief executive John Menzer. Foreign sales reached a lofty 18% during the most recent quarter and over the next several years the company predicts its foreign locations will account for one-third of total revenues. As competition heats up at home, Dave Simons reports on the outlook for the retailing giant.

mall, category killers (otherwise known as “big-box” stores) were easier to access than the stores in the mall. They offered boatloads of parking and aisle space and, because they could sell any number of items in unprecedented quantities, had the ability to severely under-price the competition. Ultimately, one big-boxer would emerge as the industry’s most significant, respected and feared deep-discount provider – the Bentonville, Arkansas-based Wal-Mart Stores Inc. The success of Wal-Mart – founded in 1962 by the late Sam Walton and currently with some 4,300 stores worldwide – is difficult to gauge in basic economic terms. But consider this: with yearly revenue of approximately $245bn, Wal-Mart is not just the world’s dominant retailer; it is the largest single

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SECTOR PROFILE: WAL-MART

enterprise on the planet, with a personnel roster seemingly invincible retail establishments, from Kmart to approaching a city-building 1.4m. Wal-Mart’s international Caldor, Woolco to Ames, quickly bit the dust, powerless to division alone accounts for nearly $50bn in revenues – or compete on a Wal-Mart-sized scale. New Wal-Mart stores often appeared in the same space vacated by one of its about $10bn more per year than software giant Microsoft. To some, Wal-Mart is a classic case of capitalism on competitors. For better or for worse, Wal-Mart and others rocket fuel. To others, it represents a sea change in global like it irrevocably changed the way consumers approach the business of shopping. economics. For years the dime-store patriarchs of Retailers impacted by diverse spending patterns the United States (US), Wage War 130 such as Woolworth’s and And yet despite posting 120 Kresge’s, existed to some very admirable 110 provide customers with a numbers under some very 100 lower-priced alternative challenging economic 90 to the big department conditions, observers 80 stores of the day. already note the 70 Subsequent retailing appearance of stress 60 operations including fractures in the company’s 50 Ames, Kmart and Caldor seemingly indestructible extended the concept foundation. Wal-Mart’s FTSE All-World Developed Wal-Mart Stores into the regional-mall third-quarter earnings of FTSE All-World Developed – General Retailers era. Wal-Mart, on the 54 cents per share were in Data as at 29th October 2004. Source: FTSE Group other hand, took the line with analyst deep-discount dictum into uncharted territory. It was not expectations, and the company indicated its full-year enough to have one discount, said founder Sam Walton. In profits would be better than previously forecast. However, other words, once prices dropped, they needed to keep traders were less than impressed with the company’s dropping, year after year after year. To help spread the domestic sales, which were up just 9.7% for the quarter, word, Wal-Mart settled on its now-famous “everyday low the slowest growth rate in over 18 months, while noting prices” slogan, complete with whistling smiley-faced icon that portions of Wal-Mart’s earnings came from nonthat presided over each and every “rollback.” operating items. Skeptical analysts called Wal-Mart’s nearSustaining the Walton philosophy has meant adopting term profit analysis overly optimistic. and promoting an aggressive set of marketing, managing “It was a pretty low quality quarter with cost pressures and cost-saving principles. A champion of emerging continuing to be a problem and the management’s tone computer technology, early on Wal-Mart instituted a was overly bullish,” counters longtime Wal-Mart analyst sophisticated software-tracking system that allowed Emme Kozloff of Bernstein Research. Domestic fuel prices, managers to keep tabs on the hottest-selling items, thereby which spent the balance of 2004 in the $2-per-gallon streamlining both inventory and delivery. As it steamrolled range, may be Wal-Mart’s biggest adversary going forward. across the US (and elsewhere) during the 1990s, Wal-Mart “Higher gas prices are taking away from the spending rang up quarter after quarter of big profits by selling power of the consumer, and it is even more pronounced for massive quantities of popular products at a fraction of their lower-income consumers,” says WR Hambrecht retail competitor’s prices, sometimes at whisker-thin margins. analyst David Yamamoto. The bigger-is-better approach became standard operating Keeping a tight lid on operating costs is central to Walprocedure for nearly every big-box provider on the planet. Mart’s lowest-price formula, to the point that it remains Before long, everything from peanuts to aspirin tablets among the tightest of all major employers, typically starting was suddenly available in containers nearly the size of an its workers at less than $8 per hour. By comparison, oil drum. As the retail dynamic shifted, dozens of wholesale giant Costco, a leading Wal-Mart competitor,

Wal-Mart Stores Inc Costco Wholesale Corp Sears Roebuck & Co Home Depot

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SEDOL

Exchange

Country

Economic Group

Sector

2936921 2701271 2787312 2434209

New York NASDAQ New York New York

USA USA USA USA

Cyclical Cyclical Cyclical Cyclical

General General General General

Services Services Services Services

(50) (50) (50) (50)

Retailers Retailers Retailers Retailers

(52) (52) (52) (52)

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offers its employees a minimum of $10 an hour to start. has meant cutting back on payroll and other operating Wal-Mart has makes no apologies for its opposition to expenses, not to mention shopping for goods and services wage-challenging unions. “Because we believe in on the cheap overseas. And Wal-Mart itself, whose maintaining an environment of open communications,” founder once wrote a book entitled Made in America, is reads a company memorandum,“we do not believe there is itself no stranger to outsourcing. “Wal-Mart is not just a seller of products, it sets a need for third-party representation.”However, earlier last standards,” notes Bob Ortega, year the company was forced to reporter for the Wall Street Journal deal with its first serious union Reproduced with the kind and author of In Sam We Trust: The stand-off north of the border in permission of Wal-Mart Untold Story of Sam Walton and Canada. And in November, WalHow Wal-Mart Is Devouring Mart announced that it would America. “When Wal-Mart dictates allow branches of the official to a wholesaler how much it will Communist Party-controlled pay for shirts, for example, the union in its Chinese stores, after wholesaler must then decide the All China Federation of Trade where the shirts will be produced, Unions threatened legal action. based on its ability to meet WalThe company is also party to a Mart’s financial demands. Which potentially significant class-action often means looking overseas and lawsuit charging discrimination finding the cheapest source of against female employees, which labor available.” was allowed to proceed earlier this year by a Federal judge. It is the largest civil-rights class action in Targeted history. And yet because of its Although Wal-Mart may be well sheer size, Wal-Mart may very well ahead in the retail race, that is not emerge from a unfavorable stopping a few seasoned judgment relatively unscathed. competitors from attempting to “A settlement or judgment in the billions of dollars close the gap. With revenues of approximately $42bn, Target wouldn’t necessarily be a death-blow to Wal-Mart,” Corporation (TGT) would not appear to be a serious threat observes Bernstein’s Kozloff. “Every $1bn of pretax to the Wal-Mart regime. Yet within the past several years, settlement damages translates into about 15 cents of Target has established itself as a slightly more diverse and earnings per share.” Meaning that Wal-Mart could upscale alternative, and more often than not can be found potentially cover a $10bn settlement hit “with cash on within a stone’s throw of the neighborhood Wal-Mart. A far hand and cash flow,”says Kozloff. more intriguing adversary is Costco Wholesale Corp. (COST), which operates a chain of wholesale warehouses (and is a direct competitor of Wal-Mart’s wholesale Supply Demands Wal-Mart is particularly frugal when it comes to offshoot, SAM’S CLUB. Though it too lags Wal-Mart in size, stocking its shelves. To help the company maintain its Costco pays an hourly rate that is, in some instances, more falling-prices quota, Wal-Mart’s suppliers must follow a than twice that of Wal-Mart’s and offers its workers strict set of guidelines, including the stipulation that generous health benefits to boot. Not surprisingly, Costco’s prices on “standard” goods purchased by Wal-Mart drop rate of employee turnover is around 24%, one of the best in each successive year. Wal-Mart’s enormous purchasing the retail industry. By comparison, one-in-two Wal-Mart power has put many a supplier between a rock and a hard sales associates hang up the red shirts within a year. Wal-Mart’s most noteworthy challenger came together place; with fuel costs, health insurance and other expenses on the rise, remaining on Wal-Mart’s client list unexpectedly in November, when discount retailer Kmart

Sub Sector

Full Market Cap (millions USD)

Market Cap*

Discount & Super Stores and Warehouses (524) Discount & Super Stores and Warehouses (524) Discount & Super Stores and Warehouses (524) Retailers - Hardlines (526)

231,250 21,913 7,448 90,189

Large Large Large Large

Cap Cap Cap Cap

Data as at: 29th October 2004, FTSE Group * In FTSE Global Equity Index Series

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announced the acquisition of department-store stalwart Sears, Roebuck & Company in a deal valued at $11bn. The country’s former Number One-ranked discount store, Kmart became the bloody fish to Wal-Mart’s great white shark during the late 1990s, and in 2002 declared bankruptcy. But the company soon re-emerged under the guidance of new chairman Edward Lampert. Since that time, Kmart’s stock has vaulted over the $100 mark from a low of $12. With combined revenue of $55bn, the new company, known as Sears Holding Corp., ranks third behind building-supply retailer Home Depot. Though the prospect of two former losers combining to equal one winner may seem far-fetched at first glance, the companies’ substantial assets and cash reserves make them a force to be reckoned with. “It is a dream deal,” asserts Kurt Barnard, head of Barnard's Retail Consulting Group.“Both will achieve tremendous cost savings which will bring about lower prices. They will give Wal-Mart a run for its money.”

upbeat about Wal-Mart’s overseas prospects over the long haul. “Despite the challenges, Wal-Mart will undoubtedly emerge as a truly global retailer with leading market positions in Europe, Japan, and emerging markets – places where their presence is limited today,”he says.

Up Against the Wal

Maligned, championed, feared, loved – rarely has a business invoked such strong feelings as Wal-Mart. Proposed Wal-Mart sites are regularly accompanied by a wave of political and small-business opposition; watchdog web sites ranging from “The Wal-Mart You Don’t Know” and “Wal-Mart Watch”to more blatant forms of opposition (WalmartSucks.com) have been an Internet fixture for many a year. According to Bob Ortega, the same methodical approach to business-building that made Wal-Mart’s late founder Sam Walton a multi-billionaire has also created the atmosphere of distrust which continually follows the company from town to town.“This is the largest retailer in the world,” says Ortega, “and they are also the most International Growth Global expansion is a top priority for Wal-Mart, which aggressive in terms of expansion. And they tend to go into began to solidify its non-domestic base a decade ago with the smaller towns than some of their competitors. Additionally, Wal-Mart typically draws a fairly formation of Wal-Mart International, currently led by chief executive John Menzer. Foreign sales reached a lofty 18% substantial percentage of their business from local existing during the most recent quarter, and over the next several businesses, even though the company claims they draw their business from a 20-mile years the company predicts its radius. But the interesting foreign locations will account thing is that there are towns for one-third of total While the company is partnered in the where people have been revenues. At present, WalUnited Kingdom with food-and-clothing outraged that a Wal-Mart Mart’s strongest market is retailer Asda and it has also made inroads was coming in, when they Mexico (where it is known as already had every other Wal-Mex), which registered a in the Orient, a conspicuous amount of major giant in the town. The 30% year-over-year increase white space can be found throughout fact is that Wal-Mart attracts in new store openings, continental Europe. more opposition than, say, a according to Amy Wyatt of Target or a Kmart, when in Wal-Mart International fact there’s not much Corporate Affairs. However, the Wal-Mart map looks considerably less difference – except for the fact that Wal-Mart is faster, impressive on the other side of the pond. While the tougher and more aggressive.” On the surface, Wal-Mart seems to have little interest in company is partnered in the United Kingdom with foodand-clothing retailer Asda and it has also made inroads in offsetting the perception of a company with an agenda. the Orient, a conspicuous amount of white space can be Communications are closely guarded; executive found throughout continental Europe. “Europe is an interviews are few and far between. As it seeks to expand attractive market,”contends Wyatt,“we are always looking its worldwide presence, Wal-Mart remains an enigma, a for new opportunities where it makes sense for our long company that brings to any new region the promise of jobs and affordable goods, yet often with an unmistakable term growth and where customers want to see us.” Where exactly that is remains a big question mark. In air of arrogance. Asked to describe Wal-Mart’s strategy for reducing the Germany, for instance, where shoppers are accustomed to hunting for the lowest price, as opposed to having them cost of fabrics by encouraging competition among foreign available on a daily basis, Wal-Mart operations have moved producers, Ken Eaton, head of Wal-Mart’s global procurement division, put it succinctly: “We’ll be putting in fits and starts. “Although it has some enviable success stories in foreign our global muscle on them.” With foreign consumers markets, Wal-Mart has seen more modest results in other growing increasingly resistant to such tough talk, it countries, and failure in others,” says Stephen Spiwak, remains to be seen whether or not Wal-Mart can bite off Retail Forward economist and author of the report Wal- a bigger piece of the global village without the villagers Mart International: The Challenge Abroad. Still, Spiwak is biting back.

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of Middle East banking Fuelled in part by high oil prices, and supported by an improved regulatory infrastructure, banks in the Middle East are growing in confidence. Profits are booming and the short term outlook is good as local banks gear up services and begin to look abroad for new revenue opportunities. So where is the catch?

ULF BANKS SAW their profits jump to over $7bn in 2003. A mid-year investigation of 67 banks in the oil-rich Gulf Cooperation Council (GCC) member states by the Middle East Economic Survey (MEES) showed profits rose by almost 20% on the previous year. Most of the region’s banks are expecting profits for 2004 to eclipse those of the prior year. According to Ghazi M. Abdul-Jawad, president and CEO of Arab Banking Corporation (ABC), “this is an exciting time, and we are currently taking advantage of our strengths to increase our market position – obtaining added value from what we are already good at.” One reason for this growing confidence is obvious. Continued buoyancy in the oil market which has seen prices hover around the $50/barrel over recent months is pumping new money into the region at large. Banks that have already reported results suggest that predictions of higher profits this year are well justified. “We have been fortunate to be operating in a positive economic environment in Saudi Arabia backed by strong oil prices” acknowledges Nemeh Sabbagh, managing director and chief executive officer (CEO), Arab National Bank (ANB) which posted an increase in net profits for the first nine months of 2004 of 53%. Liquidity is not only improving in the region’s principal oil producing countries. “The increase in global oil prices will increase investment opportunities and accelerate development in the oil-producing Arab countries and other Arab countries generally,” explained Abdel Hamid

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BANKING IN THE MIDDLE EAST

and rise The rise Shoman, deputy chairman of Jordan-based Arab Bank at the announcement of the bank’s annual results. High oil prices are nothing new to the region. In the past sustained high oil prices lubricated both Middle Eastern economies and local retail banks, which usually benefited from an upturn in deposits and corporate activity. However, the amount the banks could capitalise was often limited by high costs, restricted retail banking networks, lack of investment opportunities, poor distribution and insufficient competition. The result was that much of the region’s wealth was deposited and invested overseas. These days, however, local banks are better placed to benefit from oil-led economic growth.“At ANB we were able to take advantage of this healthy environment having already restructured our business with a clear focus on those lines of business which we believe can deliver high value added to our shareholder value,”explains Nemeh Sabbagh. Competition in home markets, customer requirements and shareholder pressure have all increased to press the banks the improve product, technology and systems, customer service and shareholder value. “Our ability to execute a well focused strategy is evident in our ability to maintain an enviable record of consistent growth in profits and superior returns to shareholders,” claims Ibrahim S. Dabdoub, CEO of National Bank of Kuwait (NBK). NBK’s strategy rests on three pillars: diversification of income sources; prudent risk management policies; and maintaining our lead in the region in terms of

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Index Performance (Rebased)

These capital flows have been particularly acute in quality “and breadth of services with an emphasis on using Saudi Arabia, the largest economy in the region. The the latest banking technologies,”he adds. Banks in the Middle East will now boast that they offer a Saudi Arabian General Investment Authority (SAGIA) service comparable to their international competitors. Most attributes much of the recent growth in the Saudi Banking banks now offer internet banking which has boosted retail sector to “the repatriation of part of the estimated $700bn operations particularly in countries with low population that had been invested in the US”. An improved regulatory densities and limited environment has acted as banking networks. Anis Al Middle Eastern states benefit from higher oil prices 55 160 a magnet for many of the Jallaf, managing director 150 funds says Nemeh and CEO of the Dubai 50 140 Sabbagh,“During the past headquartered Emirates 130 45 few years the regulatory Bank Group recently 120 environment in the Gulf attributed a large 40 110 has been enhanced and its proportion of the bank’s 100 scope significantly 41.3% profit growth over 35 90 widened. This provides a the first nine months of 80 30 healthier and more robust 2004 to be a direct result of environment in which to a series of “successful FTSE All-World Middle East & Africa FTSE All-World Middle East & Africa – Banks operate and ensures much transformations, particularly Brent Crude greater transparency in the retail banking within the banking business which has Data as at 30th November 2004. Source: FTSE Group sector,”he explains. witnessed an expansion in Better rules and its alternative delivery regulations and the need for Gulf Cooperation Council channels and new offerings to customers.” The ability to offer services such as asset management (GCC) states to comply with World Trade Organisation and Islamic banking to retail clients and treasury, corporate (WTO) rules has encouraged the region’s banks to seek finance and Islamic financing services to corporate clients banking licences in other Middle Eastern countries. – has been integral to much of the increase in turnover at Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (UAE) are already WTO members and Saudi many Middle East banks. Arabia is in pre-accession. “Investment management The resulting market used to be a low performing liberalisation makes the business for us,” explains countries increasingly ANB’s Nemeh Sabbagh, attractive as sources of new echoing the experience of revenue. Even so, local many Middle East banks. pressures remain. With many “During the past few years, GCC countries having only however, we have rearranged small domestic markets, all our investment products, regional expansion is the strengthened our team with only way to sustain future investment professionals and profit growth. have managed to achieve “Through focusing on superior overall investment evolving customer needs and returns for our clients and regional expansion, we are significantly to grow the size confident we can continue to of funds under management.” deliver strong results," It is not just current announced NBK’s Ibrahim wealth that the banks are Dabdoub at a recent press attracting. “We have conference. NBK recently witnessed an increasing flow acquired a stake in of funds back to the Gulf International Bank of Qatar and Middle East that had (formerly Grindlays Qatar previously been invested Bank) in addition to overseas” says Christian management rights. It also Kwek, head of structured inaugurated a new branch in products at BNP Paribas one Amman, Jordan highlighting of the largest international Marc Riegel, regional manager Middle East financial the fact that: “both economies banks in the region. institutions group and head of Islamic banking at BNP Paribas 4

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Crude Oil Price (USD)

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Bank, BNP Paribas and JP Morgan Chase, gained licences allowing them to become the first nonMiddle East organisations to launch wholly owned operations in Saudi Arabia. According to SAGIA, HSBC, which already has a 40% stake in Saudi British Bank (the country’s 6th Saudi banks at home largest) is also planning to Banks based in Saudi establish a wholly owned Arabia have tended not to investment bank in Riyadh. follow the pattern of the Nemeh Sabbagh GCC banks. Despite believes Saudi banks comprising five of the top should be able to hold their ten banks by market own: “Banks in the Middle capitalisation in the East, especially in Saudi region, only National Arabia have a strong Commercial Bank (NCB) market position with the largest of the 11 Saudi established networks and based banks has Middle Nemeh Sabbagh, managing director and chief executive officer (CEO), intimate knowledge of East branches outside of Arab National Bank (ANB) their markets that will the Kingdom. “We are fortunate to be operating in the largest market make it difficult for international banks to make significant in the Gulf. We believe our domestic market will continue inroads into their commercial banking businesses.” Sabbagh concedes however that “with the advent of the to expand and will offer us more opportunities for growth. As such, we will focus on our home market and have no new Capital Markets Authority in Saudi Arabia, there is current plans to expand into other countries” explains potential for international players to provide investment banking activities such as wealth management and corporate ANB’s Nemeh Sabbagh. That the Saudi Arabian banking market has its own finance advisory work where Middle Eastern banks are particular appeal has not escaped the notice of other currently not as advanced as large international players.” This may explain why BNP Paribas does not intend to Middle East banks. Following a GCC higher council resolution in December 1977, which allows GCC national compete head to head with the Saudi banks. The French banks to open branches in the GCC member countries, bank has a presence in six countries and was recently non-Saudi banks can apply for licences to operate in the awarded a licence to commence operations in Kuwait in Kingdom. Bahrain-based Gulf International Bank was the addition to its licence for Saudi Arabia. According to Jeanfirst foreign bank to win a banking licence and opened its Marc Riegel, regional manager Middle East financial institutions group and head of Islamic banking at BNP first branch, Riyadh, in 2001. In the past 18 months Emirates Bank, NBK and National Paribas,“In Islamic banking, we intend primarily to focus on Bank of Bahrain (NBB) have all entered the Saudi Arabian developing our asset management and investment banking banking market. According to Mohamed Al-Hegelan, business as we have done throughout the Middle East.” He believes that Middle East banks are used to working general manager Saudi Arabia, Emirates Bank Group plans to open 15 outlets under a phased programme, with international investment banks particularly where nonbefore extending their services to other sectors beyond regional funding is required. “Middle East banks appreciate our experience at structuring complex transactions and our retail banking. However the desire to offer retail banking was not one of well-established relationships with international investors. the primary drivers for Emirates Bank Group’s push into As long as they feel we are offering value in these areas they Saudi Arabia. In response to the decision by the Saudi will continue to work with international banks such as BNP Council of ministers to award Emirates Bank a licence to Paribas on large complex projects,”he adds. An area where both international and Middle East banks operate in the Kingdom Anis Al Jallaf, managing director and CEO of Emirates Bank declared that “the bank will are looking for future growth is in Islamic banking and focus on the opportunities of commercial financing in the finance. Islamic banking is governed by the Sharia i.e. kingdom, because there are significant opportunities for Islamic Law or Islamic jurisprudence. Islamic Sharia law provides rules that encompass the allocation of resources, project financing.” International banks have also seen the potential of Saudi capital market activities, and the distribution of income Arabia. This year three major international banks: Deutsche and wealth. are among the fastest growing in the region and appear to be on the right track towards liberalization and reforms. These two markets strengthen NBK's international presence, which distinguishes it from other banks in the region.”

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BANKING IN THE MIDDLE EAST

According to a recent report by Standard & Poor’s there looking to prosper in investment banking and wealth are now 17 fully Islamic Commercial banks in the GCC, up management in the region.“We are fully committed to both from 10 only four years ago. Anouar Hassoune, credit analyst Islamic and conventional products. However, we think that at Standard & Poor’s and author of a recent report on Islamic the seniority of our Sharia council members and our banking thinks one of the reasons for this growth is that expertise in developing Islamic financing structures and solutions now clearly Islamic financing offers demonstrates our very strong Middle East banks a way to commitment to the Middle distinguish themselves from An area where both international and East,” claims BNP Paribas’ the competition, particularly Christian Kwek. competition from Middle East banks are looking for future Jean-Marc Riegel goes even international players. growth is in Islamic banking and finance. further, “You need to be able "Smaller banks in the Gulf to offer clients the Islamic will increasingly have to deal financing option. With with the dilemma of differentiation,”thinks Hassoune.“The long-term alternative conventional products you can only sell them to conventional is clear: focus on a niche or become marginalised. As a kind clients. With a Sukuk (an Islamic bond) you can attract both of niche play, the Islamic option, particularly for smaller Islamic and non-Islamic investors so you cover the whole market. Now there is no-pricing differential on many Islamic institutions, may be a viable, long-term strategy.” Becoming a fully Sharia-compliant financial institution is financing solutions.” Whether Islamic or conventional banking Nemeh only one option. An alternative is to establish an Islamic subsidiary from scratch or through acquisition and then Sabbagh believes the prospects for the Middle East conversion (a strategy pursued by Emirates Bank). The banking sector are good. “With current oil prices likely to alternative and most widely adopted model is to launch an remain high, economic growth should be sustained during ‘Islamic window’ which incorporates separate branches, the next 12 months.” He thinks that, “the challenge for banks in the region will be to manage their growth so as to accounts, products or divisions. The point has not been lost on the international banks ensure it is sound and sustainable for the long term.”

GETTING THERE IS EASY FTSE Global Markets is your passport to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers. To discuss advertising insertions, tip-ons, supplements, sponsored sections, bookmarks or your own special requirements Contact: Paul Spendiff Tel: 44 [0] 20 7074 0021 Fax: 44 [0] 20 7074 0022 Email: paul.spendiff@berlinguer.com

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FUND ADMINISTRATION

THE TURNING POINT To meet the needs of an increasingly sophisticated client base, (while simultaneously grappling with an intensifying competitive environment and evolving manufacturing and distribution models) European investment managers are asking more and more of their third-party administrators. At the same time, clients are looking to consolidate the number of providers they use and embrace a more ‘one-stop shop’ asset servicing model. How will fund administrators reconcile the inexorable downward pressure on fees with clients’ demands for an increasingly sophisticated service? Tim Steele finds out. S INVESTMENT MANAGERS look to focus more on their core competencies – enhancing returns, developing new products – they are outsourcing an ever broader set of operational functions to external service providers. All of which is good news for administrators. This assumes, of course, that they have the necessary scale, geographic reach, technologies and plentiful investment dollars at their disposal. If the European funds industry finds itself at a critical juncture in its evolution, then it is also a moment of truth for the institutions that service them. “In the wake of the bear market, the asset management industry is experiencing change that is unprecedented both in terms of speed and scale as a result of client demand and the macro-economic environment,” says Simon Shapland, regional vice-president sales & relationship management, Europe & Middle East at RBC Global Services. “Consequently, asset servicing companies also have to evolve to keep pace with that change. A much broader range of products are becoming germane to the sort of holistic proposition that as an asset servicer (sic) you are looking to provide to your clients.”

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A major challenge within Europe are the variations between markets on the fiscal, legal and product fronts, says Margaret Harwood-Jones, head of global sales and relationship management for institutional investors at BNP Paribas Securities Services (BNPSS). “If you are to accommodate those nuances and ongoing changes at the level of those individual markets it is vital to keep investing in your business infrastructure. The closer you are to the client the better you can respond to their needs,”she says. The silver lining is that the growing sophistication of investors means the differences between the onshore European markets and their ‘offshore’ counterparts are now less pronounced, adds Harwood-Jones, and that convergence will continue over time. Julian Tregoning, marketing director at Mellon European Fund Services, notes that, while the proliferation of more efficient technologies and processes appears to dictate that costs are coming down, in practice that is not the case. The problem facing managers, he says,“is that, while customer A may be online, which is where a lot of investment dollars have been directed in recent years, customer A’s mother is not.”

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Simon Shapland, regional vice-president sales & relationship management, Europe & Middle East at RBC Global Services

In other words, a lot of money has been spent on building online capabilities (i.e. internet banking) for example, but only a proportion of clients make use of them. Providers therefore have to keep investing in new technology and maintaining old technology at the same time. However, it looks as if clients will only slowly come to embrace new technology. “With investment returns by common agreement set to be low over the next 10 years, then investment management houses’ revenues are not going to be as fat as they were in the Nineties, so controlling those costs will be ever more important,”adds Tregoning.

TABLE 1: MUTUAL FUND ADMINISTRATION – TOP TEN CLIENT PRIORITIES (in ranking order) 1. Accuracy of NAV calculations 2. Understanding of your specific needs, requirements, and objectives 3. Timeliness of NAV calculations 4. Efficiency and timeliness of settlement 5. Overall effectiveness of relationship management 6. Ability to accommodate and implement clientspecific projects 7. Efficiency in handling subscriptions, redemptions, and distributions 8. Problem resolution 9. Accuracy of reporting to investors 10.Value of services for fees charged by this provider Source: Global Custodian Mutual Fund Administration Survey 2004

Clients obviously still demand that the basics – fund accounting, relationship management – be done well (please refer to Table 1: Mutual fund administration – top ten client priorities). They also expect more proverbial ‘bang for their buck’. Products such as performance measurement and analysis that were only recently viewed as ‘value added’ are now considered to be part and parcel of even the most vanilla administration offering. With Sarbanes-Oxley and Basel II looming large (coupled with a hardening of attitude on the part of regulators in these post-Enron, Spitzer-ised times) there is also a growing demand for compliance monitoring and delivery of the management information that goes with it. For third-party providers, flexibility and scalability are vital, if they are to keep abreast of European clients’ constantly evolving priorities. “Clients want a scaleable solution because they want to grow their business and at the same time need to know that any such growth can be accommodated by the provider,” says BNPSS’ Margaret Harwood-Jones. “There is also a recognition that if providers do not have solutions that scale then it is difficult to put in place the sort of commercial arrangements that will satisfy both parties.” “There will be a big demand from investment managers in their capacity as manufacturers and/or distributors to get product to market faster than they have in the past and also to upscale, whether that is organically or through acquisition – that will clearly shape third-party administrators’ offerings to fund managers,”adds Tregoning. Similarly, the ability to meld geographic reach, breadth and depth of product offering and a flexible client-centric business model will stand a provider on good stead as clients look to consolidate the number of providers they use and embrace a more ‘one-stop shop’ asset servicing model.“From our base in Luxembourg we are seeing that shift,” says Michel Malpas, head of Dexia Fund Services. “These days we are very rarely asked to do only custody, or only transfer agency, or only fund administration. At the same time more and more value added services are coming into the basket.” RBC’s Simon Shapland also acknowledges the growing popularity of a more “holistic” asset servicing model, one that offers“a vertically integrated product set, right from core custody through fund administration, investment operations, middle office, data warehousing and management up to front office areas such as trade execution and pre-trade compliance”. In Shapland’s view, the one-stop shop is attractive because it is one way that the service provider and the end client can achieve certain results in terms of speed of integration, straight through processing (STP), and economies and efficiency of dataflow. “On the other hand,” he explains,“once you get talking to a significant regional or even a global player, then they will tell you that because of the way the market is evolving there is sometimes a case for taking a best-of-breed approach, as that builds in a greater degree of flexibility to respond to emerging trends and needs.” For his part, Mellon’s Julian Tregoning sees benefits for players of all

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sizes.“If you are a small shop, particularly one working in a single market rather than cross-border, then the one-stop shop offers the best value for outsourcing,”he says.“But, if you are a massive player, with clients across both Europe and Asia, it is very important that you can offer a consistent ‘tone of voice’ in terms of brand and service levels and any outsourcer must meet the precise demands of the distributor in order to ensure that those inter-related objectives are met.” Tregoning emphasises that providers should recognise that servicing the asset and servicing the investor are not one and the same.“In the case of the former, we are talking about everything to do with stock exchanges around the world, about custody, settling bargains and all the financials that go behind that, including tax issues pertaining to all markets in which one’s funds or portfolio is invested,”he says. “On top of that there is everything pertaining to investment accounting, not least regular portfolio valuations, as well as performance attribution, analysis and monitoring.” Accordingly, servicing the asset – while a significant undertaking – in large part relates to dealing with common data. It therefore is important that a provider can make data available on both an online and a real-time basis, as it then can be used consistently across multiple

platforms and delivered to the fund managers’ desks wherever their location. Servicing the investor, on the other hand, is an undertaking that is “agnostic” to the systems that service the asset, explains Tregoning. Apart from the asset servicing platforms pushing prices over to the client servicing systems, there really is little need for any further day-today correlation between the two. “While the end investor looks to receive his dividends and half-yearly reports, he takes it on trust that servicing the assets and the daily pricing are done correctly day in, day out,”he adds.“So all the systems are focused on the investor rather than what is going on in the asset pot.”Consequently, while a one-stop shop is a viable option on the asset servicing side, it equally is practicable for larger fund managers and distributors to maintain two outsourcing relationships, one servicing assets, the other servicing their investors. As PricewaterhouseCoopers’ (PwC) Eurofunds Survey highlighted back in 2002, many fund management companies in Europe have seen open architectures radically reshape their relationships with fund distributors. With less than 20% of European households holding funds, investment fund distributors found themselves with too many products and too few clients and as a result have

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HEDGE FUND ADMINISTRATION ENTERS THE MAINSTREAM

NLESS YOU HAVE been living under a particularly far-flung rock for the past couple of years, it will not be any big shock to learn that an ever increasing proportion of traditional long-only investment management companies are today venturing into the alternative investment space. The announcement last month (November) that Cadbury Schweppes was looking to make its first investments in hedge funds next year for its £1.3bn ($2.4bn) pension fund underscores this elevation of hedge funds to the mainstream. Although industry estimates put assets under administration within the sector at around US$700bn, the AFSR/CorrectNet hedge fund administrator survey suggested back in May that the industry had in fact already breached the magic $1trn mark thanks to year-on-year growth of over 30%. Furthermore, the past five years have seen fund of hedge funds emerge as a large stake holder in the hedge fund world: indeed, it is estimated that they account for 30-40% of both new hedge fund subscriptions and total assets under administration in the sector. A study released by The Bank of New York and consultants Casey, Quirk & Acito this past September predicted that US institutional investors’ appetite for hedge funds will increase from $60bn to $300bn over the next five years, precipitating “a significant shift in the structural and operational underpinnings of the industry”. “Successful hedge funds will have to balance investment excellence with business, operations and client service acumen if they expect to attract a meaningful share of this capital,” the study noted. “As asset managers look for ways to create satisfactory performance, they are integrating new structures, vehicles and asset classes into their way of thinking,” notes BNPSS’s Margaret HarwoodJones. “Hedge funds are no longer just for the institutional or sophisticated investor, we are seeing a merging and blurring of the institutional and retail worlds and accordingly hedge fund servicing is now much more integrated into the mainstream fund administration offering.” Given that it is an extremely demanding and complex undertaking – and, with traders resorting to ever more exotic instruments and inventive structures in their pursuit of enhanced returns in the face of eroding margins, it is only becoming more so – hedge fund administration has traditionally been the realm of prime brokers and specialist third-party providers. Custodising a share and custodising non-tangible or derivate assets are two very different tasks. Calculating net asset value (NAV) for derivative instruments requires much more sophisticated technology;

positions must be reconciled with both the manager and the prime broker on a daily basis; with hedge funds the emphasis is not so much on providing a daily valuation every day but rather ensuring that positions have been properly accounted for and recorded; and those counterparties that must be ‘touched’ when constructing a portfolio for valuation are more widely dispersed. Acquiring a hedge fund administrator, replete with its specialist staff and tailored technology, has therefore emerged as the most popular option, offering as it does a faster route to market and ostensibly greater credibility upon arrival. Accordingly, over the past two years or so we have seen BISYS purchase Hemisphere, the largest hedge fund administrator in Europe and the third largest globally, before snapping up New York-based DML Fund Services Group. Soon afterwards State Street acquired International Fund Services (IFS) and The Bank of New York took over International Fund Administration (IFA). More recently HSBC bought Bank of Bermuda, Forum Financial was subsumed by Citigroup and most recently in July JPMorgan acquired Tranaut Fund Administration. Morgan Stanley is the only new entrant to break the mould, announcing in June that it was to build its own hedge fund administration and services business. However, Michel Malpas at Dexia Fund Services – which has built up a near 20% market share of France’s alternative asset management sector (which, incidentally, is currently one of the most developed in Europe) – applauds Morgan’s decision. “We have seen a move by large custodians to buy boutique hedge fund managers, but that is very expensive and often the systems in these small companies can be quite weak,” says Malpas. “We certainly preferred to put together our own team of specialists and we want just one system, as it offers coherence and economies of scale.” Julian Tregoning at Mellon is adamant that any administrator looking to be a global player must be able to service hedge funds and also funds of hedge funds. He also believes that the arrival on the scene of the large banks will speed a long overdue shake-up of the existing market structure. “The role of the prime broker has always been too close to that of the fund manager,” he says. “My view is that going forward the role of the prime broker will diminish in administration terms and we may see a useful fiduciary divorcing of the administration and valuation of a portfolio from all those activities which fall under the general heading of broking, such as deposit matching and so on. In the future we therefore are likely to see a scenario where you have a hedge fund manager liaising separately with a prime broker and an administrator.”

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moved to reduce the number of fund providers with whom they deal. Their goal now is to focus on long-term partnerships, PwC noted, with those providers that can best support their sales efforts. This realignment of priorities has left the fund manufacturers struggling to service those distributors in a profitable manner. The open architecture model is seen to be the one that will ultimately prevail, as it offers the greatest choice to the end client, so as a fund group it is important to get your fund referenced with as many distributors as possible. “The market is developing almost every day, and while the open architecture model is not something that is not quite there yet, it is nonetheless coming though and it is the future,”says Dexia’s Michel Malpas.“Equally, there is a need to develop a standard way to process funds, and that too is not yet here.” Indeed, despite the progress made in this space by Euroclear and Clearstream with their respective FundSettle and Vestima offerings, the sort of efficiencies and cost savings enjoyed by the US funds industry thanks to the FundSERV processing platform have yet to materialise in Europe. Adds Malpas: “The operational side remains very complex. Exchanging and selling products is one thing, but you also have deal with language issues and diverse registration requirements. Certainly that is a gap that Dexia is looking to fill – if you can help control distribution then as an administrator you will be in a strong position.” Margaret Harwood-Jones agrees. “Everyone knows that distribution and distribution strategies are at the heart of a fund manager’s success, and when you look at the complexity of Europe the barriers to entry in individual markets seem daunting,”she says. Accordingly, BNPSS has seen a huge demand for services in support of distribution, not only to deal with the logistics and mechanics of that activity but also to offer clients administration services or to help manage the information generated around those services.“For instance, we can provide the asset manager with a consolidated report showing what was traded the day before, the markets they were traded in and the distribution channels those sales emanated from,” says Harwood-Jones. “That can be very powerful in allowing the client to unlock the complexities found in Europe.” Simon Shapland identifies a significant move away from the primary register into secondary registers, driven by the growth of fund supermarkets and the dissemination of distribution muscle down to IFA networks or their equivalents. As that occurs in the home onshore markets, new asset servicing challenges arise, says Shapland.“Particularly for the large manufacturers, onshore retail transfer agency is still very highly decoupled from the institutional transfer agency and the other asset servicing requirements,”he says. As that moves away from them into the secondary registers and into the fund supermarkets, “then the focus shifts to how they can launch into new geographical markets and new vertical markets and how they support those infrastructures. Accordingly the asset servicing proposition is going to go through a lot of restructuring in

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

Margaret Harwood-Jones, head of global sales and relationship management for institutional investors at BNP Paribas Securities Services

“Everyone knows that distribution and distribution strategies are at the heart of a fund manager’s success...” the next three to five years as we follow our clients in new directions,”continues Shapland. The big question going forward is how fund administrators are going to reconcile the inexorable downward pressure on fees with clients’ demands for an increasingly sophisticated service. The answer is that many in all likelihood will fail to do so: scale economies will become still more important and consolidation seems inevitable. “It is a no-brainer. A ‘crunching down’ of providers is inevitable,” says Julian Tregoning, although he believes there will still be room for a very small number of specialist providers, if only in the domestic markets. Michel Malpas agrees: “The market is consolidating – in the short term there is pressure on price because large global custodians are buying into the market, but in the long term the investments required to compete are getting higher and higher, and some players could struggle to keep pace.” Malpas admits that Dexia Fund Services is itself looking into forging a partnership with another service provider, possibly in North America. “That makes the most sense in terms of effectively expanding our global market coverage,”he explains. However, while acknowledging that a further concentration of both assets under management and assets under administration around a select number of providers is inevitable, Simon Shapland stresses that this scenario is not necessarily imminent. “As we see expansion on an international basis into more and more markets and products, new entrants will be attracted from the periphery of the market, so any consolidation may not happen as fast as people expect,”he says.

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TRANSITION MANAGEMENT

AIMING FOR A D GOLD STANDARD

Implementation shortfall – the differential between the transition portfolio and the target portfolio, assuming the transition could have proceeded instantaneously (and without cost) is increasingly used as a post-trade measurement tool of choice. Is belief in implementation shortfall as the right measure of performance justified? Francesca Carnevale reports.

Tony Nash, head of transition management at Deutsche Bank

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O YOU GET a performance related money-back guarantee from your transition manager? If Deutsche Bank has its way, you certainly will. The bank’s transition management team has introduced shortfall-linked compensation, guaranteeing its clients a refund on its commission if it does not. It is an issue of “accountability”says Tony Nash, head of transition management at Deutsche Bank. “If a transition team does a good job, then it earns commission. If a transition team does a bad job, it also earns commission,” explains Nash “Where is the incentive for repeat business in that kind of relationship? It must ultimately reside in accountability; or more specifically, for a transition team to accept it is accountable for its services.” While repeat business has traditionally been the mainstay for incumbent transition management providers, clients are now fully aware of the competitive environment and are quite rightly looking to use this to their own advantage by putting transitions up for competitive tender. However, the move by Nash and his team is not a short term or un-substantive marketing ploy. It is a serious attempt to introduce professional rigour and to kick-start a commitment to accurate performance measurement in a market that is still finding its feet. Deutsche Bank is not alone. According to Lachlan French, head of transition management in Europe for State Street “we are very interested in seeing the development of a standard which allows like for like comparison between different transitions and different managers. This model is likely to analyse the relationship between performance and the characteristics of the transitions but it will only make sense if it is a standard adopted across the entire market”. Traditionally, performance in transition management rests on two pillars. The first is the provision of real time, complex analytics that follow and measure (or track) the status and performance of assets throughout the entire transition process.This includes pre-trade estimates, transition reporting and post-trade cost analysis. Prior to implementing a transition, for example, pre-trade analysis of investment risk and operational risk is undertaken in conjunction with a risk management plan. These costs include commissions, market impact and opportunity costs. To facilitate risk management throughout the transition, the transition manager controls trading to minimise country, currency, sector, size and style biases within the portfolios. This is performed while maintaining a market exposure based on the target asset allocation. Optimal trading will reduce transaction costs.

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clear and transparent. But it is also Following the transition, an a regulated business in that we are extensive post-trade analysis is regulated by the FSA.” performed that includes benchmark The importance of accountability analysis which compares investment and cost effectiveness of portfolio performance for the period versus transitions was starkly highlighted in pre-trade benchmarks as well as a letter of February 2004 to the summary reports that detail United States’ Securities and transition activity and trading Exchange Commission from strategies used. “In any transaction, Vanguard Group Inc., managing you see a wide differential in cost. It director and chief investment officer is a hoary chestnut, but each George U. Sauter, who stated: transition is different,” says Stan “Common sense dictates that, all Proszek, director, trade management things being equal, a fund with lower services at Royal Bank of Canada. total costs will outperform a fund “One notable trend is that investors with higher costs. There are are undoubtedly becoming more numerous academic studies that knowledgeable and have greater confirm the importance of costs in expectations. Transition managers determining performance. Costs are will have to meet that challenge Paul Marchington, head of transition not limited to the operating costs head on.” management at Lehman Brothers in London included in the expense ratio of a As investment managers become more sophisticated the demand for more than vanilla mutual fund, but also include portfolio transaction costs, execution strategies continues to propel the boundaries of which are frequently misunderstood and systematically the transition management business, agrees Nash. But the underestimated by investors. We strongly support increasing client, no matter how sophisticated remains at the mercy of investors’ awareness of transaction costs and their impact on the transition manager’s performance. “Presently there is investment returns.” reluctance from transition managers to take responsibility of the risk of deviation from their pre-trade cost estimates – Successful transitons there is something missing in that equation.” And that is What makes a successful transition? Is cost really an where his guarantee now comes in. “If our estimates are not issue these days? To some specialists cost is only one of the matched by performance, we will hand back commission to key measures of success. “We believe that the success of a customers,”he adds. transition should be measured against a number of One of the difficulties admits Nash is that implementation qualitative and quantitative benchmarks including: shortfall can mean different things to different people. “In objective fulfilment, the quality of service provided, our case we use a transparent and clear measurement of the implementation shortfall (cost), benchmark deviation and movement of funds, including commissions, taxes, intra-day operational success,” says Paul Marchington, head of and inter-day movements.” He goes on to explain that transition management at Lehman Brothers in London. Deutsche will synthetically create a spread of outcomes on a “Consistency of objective measurement has to cover beta basis, resulting in a normal distribution graph of two broad categories. Forecasting (or cost estimation) returns. “A single figure will never be accurate,” concedes and reporting,” confirms Kevin Hardy, Northern Trust’s Nash, “it is always best to give a range: a best and worst case Global Investor’s global head of transition management. with a 95% degree of confidence.” “These should be further sub-grouped into qualitative Reliability of service is everything. Large transits can and quantitative.” move markets and the sums involved are often huge. State “The current discussions of objective measurement are Street alone transited some $275bn worth of assets in 2003. currently focusing on one of these areas: quantitative Lachlan French at State Street says, “the challenge for reporting,” agrees Marchington. “While this is obviously a investors is enormous. As the number of providers grows, crucial step forward, it still leaves asset owners the open the investor is faced with a harder job of understanding the question of “How do I select the best transition manager true differences between those providers. That is why for my needs when there is no consistency in the cost standards are so important. One of the key things clients estimates they provide?” An example of this is that while want is trust and reliability in the transition provider. While most transition managers can provide extensive statistical for our clients transition performance has obviously been profiling of the assets as part of their cost estimation key they also place a great deal of trust in us because of the process, “many omit to include the critical analysis of the high level of transparency in our process.” precise execution methodology to be used,”he adds. The transition management business is, in itself, a What are the main pitfalls to watch for in a transition? transparent process, maintains French, “it is a very clean “Cost, process, risk management,” says Northern Trust’s business. It is not a business that involves soft dollar. It is Hardy. However, says Marchington “Foreign exchange –

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ironically the most volatile asset class, FX, is largely overlooked in both terms of analysis and execution.” Other areas to highlight for investment managers are cross asset class risk, “where risk attribution is often provided on an asset class dependent basis, with accounting for the significance of cross asset exposure,” explains Marchington and fixed income, where the lack of price transparency and comprehensive risk analytics has historically left fixed income execution veiled in uncertainty. Asset owners can also be sent down blind alleys. A transition costing, for example, 10 basis points has to be weighed against the opportunity cost. If the pricing is good and then it takes six months to sort out the reconciliation, what is point in that? Furthermore there is the question of when is more information too much information? “Our job as transition manager is to analyse, and risk assess, every eventuality,”concedes Marchington. “However, how much detail does an asset owner want to see? There is a grey line between outlining every risk or potential cost and creating outright fear.” John Minderides, head of transition management at JPMorgan is sanguine: “I have mixed views on the need for benchmarks. No transparency, no information – it is not

good for the client. But simple comparisons of one transition performance versus another without proper explanation and appropriate normalisation to pre-trade analysis can be very misleading.” Minderides is not alone.“While we fully support moves to further increase transparency and consistency of performance measurement, it is also important to put this issue in perspective. The transition business was born from the client’s needs for performance attribution and accountability during the restructuring of assets, in a time that there was none,”says Marchington. “Transition managers have come a long way in providing a more transparent and efficient restructuring platform to clients,” says Northern Trust’s Hardy. “Of course there are still improvements that can be made. But the jury is still out on implementation shortfall as the best measure of performance. Cost is a double edged sword and trying for a standard in this business is still some way off.” Some managers will look at margin, others at commissions, others will consider holistic cost, he adds. Invariably the market is moving towards performance solutions, the question is how quickly. “As with any business evolution is a key ingredient of growth,” concludes Hardy.

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extend their

OBLIGATIONS FONCIERES

French bonds

horizon Issuance of French covered bonds – obligations foncières – was up by around 20% in 2004 over 2003, bringing the total amount of the instruments outstanding at the end of the year up to €90bn. Furthermore, investor appetite for them in Europe and Asia shows no sign of abating. Issuers and arrangers are generally bullish. Is the outlook as good as everyone says it is? Andrew Cavenagh reports.

HE TWO LEADING issuers of obligations foncières (OF) enjoyed substantially bigger volumes in 2004. The largest, the Compagnie de Financement Foncier (CFF), the subsidiary of France's third largest banking network Groupe Caisse d'Epargne, is expecting to see a year-on-year growth of between 10% and 20%, which would take its total this year to somewhere between €11bn and €12bn from €9.6bn in 2003. Thierry Sessin, head of investor relations at CFF, says further transactions before the end of the December would see the overall level of outstanding bonds rise from the current level of €38bn to €40bn, cementing CFF’s preeminent position in the market.“We will continue to be the biggest issuer of OF in Europe,”he says.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

On top of the CFF portfolio, Group Caisse d’Epargne has a further €6bn of covered bonds outstanding through the Vauban Mobilisations Garanties programme of structured instruments, which was established two years before the Government passed the law for OF in 1999. Sessin says that the outlook suggests further growth in 2005 as the Groupe Caisse d'Epargne's acquisition of a controlling interest in CDC IXIS in July 2004 had increased the group's portfolios of mortgages and public-sector loans. “The volume of outstanding eligible assets that we can refinance is bigger than before.” This month, for instance, almost all loans that Crédit Foncier de France (the CFF parent) will be transferred to Credecureuil, the Caisses d’Epargnes computerised

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OBLIGATIONS FONCIERES

community platform. The move will enable CFF to buy mortgages loans directly from the Caisse d’Epargne group directly through the platform from 2006 onwards. Meanwhile Dexia MA (Municipal Agency), the issuer that has a €45bn euro-equivalent programme to refinance only public-sector loans, will also see its levels of issuance in 2004 exceed its plan for the year – somewhere between €7bn and €8bn. The €1bn benchmark bond that the agency launched out of the programme in September was the 115th in the series and brought its total amount of debt issued up to €36.3bn. A spokeswoman says subsequent private placements had now taken the annual total over the high end of the expectations at the start of the year.“At this stage we have issued more than €8bn.” Only CIF Euromortgage, the main funding tool of the only mortgage group for individuals, Crédit Immobilier de France, has seen its OF outstandings rise from €7.1bn at the end of 2003 to €10.3bn by the middle of November 2004. The issues amounted to €3.17bn this year and the last issue

Stephanie Ferrieu, AVP analyst at Moody’s Investor Services

launched in November (valued at €1.25bn) “was a great success,” says Alain Marcel, head of investor relations at CIF. Marcel says “investor demand exceeded our target and in fact reflected a diversified investor base that was widely spread and especially strong in Asia. Central banks constituted the main category.” Marcel stresses that CIF is still a relatively “new company” – having entered the market in 2001 – with a surplus of assets to refinance. “This year we are in a regular trend, which is different,” Marcel explains. He says CIF should nevertheless issue between €3bn and €4bn in 2005, “reflecting the strong activity of the group”. The increasing appetite of foreign investors for the bonds has been a key factor in the continued growth of the market. For example, the last jumbo issue that CFF had launched in October – a €1bn bond with a seven-year maturity – was sold overwhelmingly to overseas central banks, asset managers, and commercial banks. French investors bought just 19% of the issue, while Scandinavian investors had accounted for 29% and Asian ones for a further 23%. “It is proof of the appetite of foreign investors,” claims Sessin.“Maybe it is because of the capacity of the French market to absorb covered bonds, but we are increasingly becoming an international issuer. They want to increase the amount of euros in their portfolios and they have a choice between sovereigns, agencies and the best covered bond issuers.” The diversification of investors in the CCF issue is reflective of the OF market at large. According to Rob Whicello, head of frequent issuer syndicate at BNP Paribas, “domestic investors continue to play a large role in OF issuance but there has been noticeable uptake from Asian accounts. This appetite has come specifically from the Asian central banks which are familiar with the OF issuers after many road shows and are comfortable with the format and legislation.” According to figures from the European Mortgage Federation, euro-denominated bonds accounted for 75% of the OF issued by November 2004, with US dollars the next most popular currency at 14%. Sterling (7%), Swiss francs (4%) and Hong Kong dollars (0.2%) made up the balance. (See Chart 1: The breakdown by currency for obligations foncières issued in 2004.)

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Dexia and CIF Euromortgage have also observed a further strengthening in foreign demand for their bonds. Dexia’s spokeswoman highlighted the continuing increase in Asia for the agency’s benchmark euro issues. “It was already the case last year, and the Asian accounts are opening more and more to euros,”she says.“Now they are increasingly present in our benchmark issues.” And while the agency now had an “established international placement in many, many geographical zones”, she insisted it was still looking to expand its investor base further.“We are continuing to diversify.” “It is absolutely clear that (our investor base) is now worldwide,” adds Marcel at CIF Euromortgage. “This year we have new investors in Asia, and the diversification of our investor base is clearly improving further.” The signs are that the market will continue to grow. CFF is certainly in no doubt that its issuance will take another significant step-up next year. “In 2005, we expect to have between €12bn and €14bn of issuance,”says Sessin.“CFF is a group with a strong dynamic.” He insisted, however, that the bank remained committed to stable growth based on maintaining the quality of its assets – the loan-to-value ratios on the mortgages in its portfolios average just 51% with a high proportion covered by state guarantees – and its programme would not be susceptible to fluctuating market conditions. “We are not an opportunistic issuer,”says Sessin.“We want to achieve a low spread on the pricing in the secondary market. For certain maturities we can achieve a pricing near to the (government) agencies.” One change CFF will make, however, is increasing use of residential mortgage backed securities rather than direct mortgage loans to back its bonds. Both CIF Euromortgage and VMG use RMBS exclusively for this purpose, and its offers advantages both in terms of credit management and scale. “The credit risk of the asset is managed at the level of the RMBS,” explained Stephanie Ferrieu, AVP analyst at Moody’s Investor Services. She also says the impressive volume of European RMBS paper makes it easier now to accumulate a “critical mass” of the underlying assets in order to issue “jumbo” OF. In addition, it allows improved asset diversification through the combination of RMBS from various European countries. Outside observers seem to feel, however, that future growth of the market for OF will be steady rather than spectacular. “I’ve not indication that there’s a large shift coming up there,” says Ted Packmohr, Dresdner Kleinwort Wasserstein’s covered bond analyst in Frankfurt. “I would guess that issuance is going to increase slightly.”BNP Paribas’ Rob Whicello meanwhile, acknowledges that OF issuance by the three leading borrowers (CFF, Dexia, CIF) could grow, although will remain roughly unchanged. Whicello says that the real growth in the European covered bond market will come from new jurisdictions such as Italy and Portugal.“The OF market is a mature one with an existing legal framework, sufficient liquidity and an established investor base. However

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

the newer markets, like Portugal and Italy, are areas which will offer exciting opportunities in the near future as covered bond issuance takes off in those areas. Christoph Anhamm, an analyst at ABN AMRO in Frankfurt, says while OF certainly offered investors a very stable market – with three established issuers all of whom had secure triple-A ratings – it was not the most liquid one for covered bonds and that was likely to inhibit its growth. “There’s other covered bond markets that produce a slightly higher degree of liquidity than the French one,” says Anhamm. He pointed out that the average size of the outstanding CFF issues was just €1.6bn, compared with €1.7bn for all covered bonds, €2bn for the UK and Spanish products and €2.8bn for the issues out of Ireland. A further sign of the lower degree of liquidity of some OF was that only two of the CFF bonds were currently available on Eurocredit MTS – the most common electronic trading platform. It was certainly “highly unrealistic” to expect it ever to challenge the German Pfandbriefe market in scale in the near future. The liquidity of the market could potentially improve with the emergence of more issuers. Ferrieu at Moody's

One change CFF will make, however, is increasing use of residential mortgage backed securities rather than direct mortgage loans to back its bonds. Both CIF Euromortgage and VMG use RMBS exclusively for this purpose, and its offers advantages both in terms of credit management and scale.

Chart 1: The breakdown by currency for obligation foncières issued in 2004 ■ ■ ■ ■ ■

EUR USD GBP CHF HKD$

75% 14% 7% 4% 0.2%

Source: Compagnie de Financement Foncier 2004

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says that the greater volume of mortgage lending in France over recent years should maintain the positive trend of OF issues. There is a lot of mortgage lending to refinance,”she comments.“It is a good refinancing tool for the specialised mortgage lender.” “What makes this market really interesting is that you have three issuers who follow very, very different business strategies,”adds Packmohr at DKW.“It is a relatively young market still.” “In terms of the underlying mortgages available, the size of the market could be much greater,” agreed ABN AMRO’s Anhamm. “There is probably room for more (issuers), but I haven’t heard of anyone planning that.” He says he thought the biggest deterrent for new issuers were the restrictive rules – over and above the legal framework governing the instruments – which the rating agencies had agreed with the existing issuers on the

management of assets and liabilities. “No one else has suggested to me that they want to issue OF,” adds Helene Herberlein, senior director for European covered bonds at Fitch Ratings. “It has been a bit disappointing from that point of view. As long as you don’t get any new issuers on board, the growth rate will be more subdued.” She says that part of the problem was that the French mortgage banks were mostly well rated and also – in many cases – had access to cheap funding from retained deposits. While OF were not just for mortgage refinancing, this was clearly an impediment to the emergence of new issuers and a rapid expansion of the market. In the absence of more French issuers, the analysts are looking to first-time countries to bring new entrants to the market in 2005. “Next year we expect more to come from Sweden and Italy,”says Packmohr. What does seem certain is that obligation foncières – in which mortgage assets and public-sector loans can be combined unlike German Pfandbriefe – will be around in their present form for the foreseeable future and not become subsumed into some type of uniform European covered bond. For there is broad consensus among the market participants and analysts that attempts to develop a common legal framework for then instruments have a long way to go.

Outside observers seem to feel, however, that future growth of the market for obligations foncières will be steady rather than spectacular.

Christoph Anhamm, senior covered bond analyst at ABN-AMRO

“I don’t see that coming in the near team – and I don’t see the need actually,”says Packmohr at DKW.“I think it is a long way down the road, but what we do see is the national frameworks moving closer together. There are other ways to bring the market forward,”he concluded. While he acknowledged that there would be potential advantages of a common framework in terms of greater transparency, he maintained that “different issuers in different countries will have different needs”. Some of these would relate to the varying nature of the underlying collateral – such as the predominance of fixed or floating interest rates on mortgages in different jurisdictions. “Every new country coming on board wants to do something a bit better than its neighbours,”adds Herberlein at Fitch.“We do not expect a complete legal harmonisation in the near future,” concurs Raimon Royo, director for European covered bonds at Fitch. However, he also adds that differences between regimes were diminishing. “As new legislation is implemented and existing covered bond laws amended, we have witnessed considerable convergence in the covered bond regimes across Europe.”

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IRISH COVERED BOND ISSUANCE ON THE RISE

HE BANK OF IRELAND aims to refinance over a quarter of its €35bn residential mortgage loan book with covered bonds over the next five years. Having the Irish legal framework for the bonds – rather than a structured instrument – has proved a distinct advantage in selling the programme to investors, reports Andrew Cavenagh. The bank successfully launched its first €2bn offering on September 13 – the issue was more than three times oversubscribed – and chief executive Michael Sweeney says it intended to launch a comparable issue in each of the next four years. “We would like to look to issue a jumbo or a benchmark (bond) every year.” Barclays Capital, Citigroup, Deutsche Bank and Davy lead managed the issue, which was marketed extensively to investors in Europe and Asia. The deal marks a watershed for Bank of Ireland and is a signal issue of growing investor appetite for covered bonds out of Ireland. The market is expected to quadruple in size over the next three years. With the launch of its initial bond, Bank of Ireland became the third issuer of covered bonds out of Dublin and the first to issue mortgagebacked instruments in the jurisdiction. Dublinbased public finance bank, Depfa Bank, and Germany’s West LB have only issued bonds backed by public sector loans. West LB and Depfa Bank have already launched more than 20 covered bonds in Ireland. Meantime, at the outset, Bank of Ireland targeted 10% of the issue for Asian investors on the strength of their increasing appetite for more established classes of covered bond, such as the French OF and the German Pfandbriefe. Bank officials consequently spoke to up to 100 potential investors in the leading Asian cities – including Tokyo, Beijing, Taipei, Hong Kong, and Singapore – and Sweeney says he expected future issues under the programme to be sold more heavily in the region. The mortgages included in the initial offering were all high-quality loans in an actively managed pool of €2.1bn, providing a collateralisation of 105%. The issuer under the programme is a wholly owned subsidiary, Bank of Ireland Mortgage Bank, into which the parent has transferred €9bn of mortgages. Bank of Ireland opted for a covered bond programme to refinance the large slice of its mortgage portfolio because it was far and away the cheapest option. Sean Crowe, director of trading at Bank of Ireland Global Markets, says the bank was paying a margin of 3-4 basis points (bp) over Libor

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on the instruments compared with a probable coupon in the high 20bps for a securitisation – a significant saving on a figure of €10bn. Crowe also says that having the Irish legal framework for the bonds – rather than a structured instrument – had proved a distinct advantage in selling the programme to investors. “The feedback from all the people we met on the road show was that the legal framework did give them additional comfort,” he observed. Crowe adds that the legal framework has the further advantage of enabling the bonds to qualify for a lower capital weighting of € 10% instead of 20%. The fact that it was the first such bond to be issued out of Dublin had proved an additional bonus, as several of the investors says they were now “overweight” with instruments from other jurisdictions. “I think there was a lot of interest in diversifying away from the established covered bond markets,” says Crowe.

“The feedback from all the people we met on the road show was that the legal framework did give them additional comfort,”

The Bank of Ireland programme should give a substantial boost to the initiative to establish Dublin as a European centre for covered bonds in a remarkably short space of time. It was only in February 2003 that Depfa launched its first €5bn five-year bond out of Ireland and followed it up three months later with a €3.5bn 10-year issue. The German investment bank West LB became the second issuer in October with a €2bn five-year issue. Following the successful launch of its first bond, West LB announced it would be recruiting substantial numbers of extra staff in the city to handle the proliferation of its programme. The bank says it had an ultimate target of raising €30bn by the end of 2005. Peter van Dessel, managing director of West LB’s covered bond operation, says the legislative and regulatory framework had been key factors in the German parent bank’s decision to invest €200m in setting up the Dublin operation. “Ireland's covered bond market is developing a strong reputation as offering an attractive alternative for quality-conscious investors who are seeking to diversify their portfolios,” van Dessel says. "These facts are represented by the investor interest in our inaugural issue.”

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US BUYOUTS LOOK UP & LOOK OUT You can’t keep a good investment strategy down. Private equity fund-raising flamed out after the dot-com bust, but venture capital and buyout firms are finding strong demand for their latest offerings. The high-yield market has re-opened to leveraged financing. Initial public offerings (IPOs) are on the rise, and a pickup in merger activity may herald the return of corporate buyers. Neil A. O'Hara reports from New York that private equity is back in vogue.

ENSION PLANS HAVE powered the recent growth in private equity funds says Carl Metzger, a partner in the private equity group at Testa, Hurwitz & Thibeault.“The returns pretty consistently (sic) have been better than the public equity markets, at least at the toptier firms,” he explains. According to Metzger plan sponsors are getting desperate after a long, cold period. The equity market collapse delivered them a doublewhammy. Asset values declined and liabilities ballooned as lower than expected returns forced sponsors to cut discount rates. Actuarial surpluses turned to deficits. These days plans are looking for higher returns from alternative asset classes – including private equity – to close the funding gap. “Even if the returns were not as dramatic as they have been, there would still be more money coming into the industry simply because people are trying to achieve greater diversification,” explains Metzger. (See Table 1: Venture Economics’ US Private Equity Performance Index (PEPI) Investment Horizon Performance through 06/30/2004.)

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No-one wants to bet the farm on private equity, but some higher average deal size. (See Table 2: Venture-Backed M&A new players have so much money that their allocations may by Year and Quarter 1999-2004.) The technology bust hit venture capital firms hard, test capacity. “While major institutional investors allocate especially firms that raised only a small percentage of big funds in 1999 and 2000. their total assets to this asset Unable to deploy so much class, even a small percentage Investors have received record capital, several managers represents, in absolute terms, distributions in the past 18 months, returned a portion to enormous sums,” says Bill including $6.6bn from Carlyle and $9bn investors and rebated fees McCormack, a partner and from KKR. collected on the excess co-chairman of the private amount. “Managers who equity group at Ropes & Gray, have done that have been “Even a slight increase in the allocation by these investors represents significant amounts.” welcomed and appreciated by limited partners, who were A rejuvenated high-yield debt market in 2004 has disappointed and surprised by the negative returns,” allowed buyout firms to sell off portfolio companies Sacks says. Leading private equity names are attracting all the accumulated through the slump.“In the last nine months, we've seen an extremely robust environment for harvesting money they want, although chastened venture capital firms buyout companies,” says Marc Sacks, a senior managing have returned to market looking for half the money or less director in the private equity division at Mesirow Financial, than they raised last time.“Over the last year, a number of “Almost daily, you are seeing buyout sponsors who bought brand names have come to market and have been able to companies in 1998, 1999, 2000 selling them at very sporty raise their targeted amounts without much trouble and in multiples.” Investors have received record distributions in record time. In these cases, most of the capital is coming the past 18 months, including $6.6bn from Carlyle and from re-ups by existing investors,”says McCormack,“Other funds, especially venture capital funds, have reduced the $9bn from KKR. Venture capitalists must envy their buyout brethren. size of their current offerings from those of the recent Although the IPO market has revived, investors remain past.” (See Table 3: Private Equity Fund-Raising by Year and leery of development-stage companies. “You have not yet Quarter, 2000-2004.) Strong performance has helped prominent buyout firms seen the public markets embrace in a wholesale way venture-backed companies that are pre-revenue, pre-cash raise record sums to tackle bigger companies.“For the first flow, that are not yet proven developed successful private time, the large private equity investors are doing deals companies,” says Sacks. However, venture-backed merger together on the front end; syndicated or club deals like the activity has picked up; after two slow years, dollar volume venture guys do,” says Colin Blaydon, Buchanan professor is on track to double in 2004 thanks to more deals and of management at the Tuck School of Business. While

Table 1: Venture Economics’ US Private Equity Performance Index (PEPI) Investment Horizon Performance through 06/30/2004 Fund Type Early/Seed VC Balanced VC Later Stage VC All Venture Small Buyouts Med Buyouts Large Buyouts Mega Buyouts All Buyouts Mezzanine All Private Equity NASDAQ S & P 500

1 Yr -2.0 11.9 18.7 7.4 14.7 14.2 19.3 26.3 23.7 13.7 18.8 26.2 17.1

3Y -18.3 -8.0 -7.0 -12.2 -1.2 -0.6 4.2 2.4 2.2 1.4 -2.0 -1.9 -2.3

5 Yr 25.7 13.2 4.6 14.4 1.0 4.1 4.1 2.9 3.1 5.2 5.7 -5.3 -3.6

10 Yr 39.8 21.4 16.8 26.7 8.7 10.2 10.5 7.3 8.5 7.4 12.9 11.2 9.9

20 Yr 19.1 13.6 13.8 15.6 27.2 17.8 14.2 9.1 12.7 9.5 13.7 13.2 13.5

Source: Thomson Venture Economics & National Venture Capital Association *The Private Equity Performance Index is based on the latest quarterly statistics from Thomson Venture Economics’ Private Equity Performance Database analyzing the cashflows and returns for over 1750 US venture capital and private equity partnerships with a capitalization of $585 billion. Sources are financial documents and schedules from Limited Partners investors and General Partners. All returns are calculated by Thomson Venture Economics from the underlying financial cashflows. Returns are net to investors after management fees and carried interest. Buyout funds sizes are defined as the following: Small: 0-250 $Mil, Medium: 250-500 $Mil, Large: 500-1000 $Mil, Mega: 1 Bil +

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Christian Oberbeck, a managing partner at Saratoga Partners

syndicates spread the risk and bring more knowledge to the table, he wonders what will happen if a company gets into trouble.“It is a new experience for these buyout guys to sit on a board with people who have a substantial investment stake from another firm,” he says, “If they see things differently, how do they work in a boardroom?” Club deals trouble major investors who have backed all the leading firms, according to McCormack.“As an overall diversification matter, investors have begun to express concern about the number of club deals where leading buy-out firms are joining together. They wonder whether they are being over-exposed should investment performance of the club deal portfolio company turn out poorly,” he says. Yet investors could benefit if syndicates reduce the number of participants in an auction.“It might take some helium out of the balloon and make an auction less likely to overprice the sale,”Blaydon notes. US private equity firms have expanded internationally, first in Europe and now Asia. “European investment opportunities are attractive because the financing markets aren’t as challenging as in previous years,” says Caroline Aboutar, a research consultant at Mercer Investment Consulting, “The exit opportunities are more attractive as well.” Privatisation and restructuring of state-owned companies fuelled private equity in Europe, but familyowned enterprises, Germany’s Mittelstand (loosely translated as middle market) and its equivalent in France

and Italy, remain largely untapped. “Will the objectives of those companies and their ownership structure find this attractive?” asks Blaydon, “Will the laws and regulations permit it to be done easily?” After several false starts, the industry has finally taken root in Japan. “There’s nothing like a large poster-child like Riverwood to make everybody realise that things in Japan really have changed and you can do it,” Blaydon says. Funds are moving into China and India, too, according to Aboutar. Private equity funds typically have a 10-year life and hold their investments for an average of five years. After about four years, when a fund is fully-invested, the manager taps the market for fresh money. “Some of the exits are being driven by private equity firms who might otherwise want to hang on to a company to ride additional gains, but feel they need to generate some realised gains in anticipation of their next fund-raising,” Sacks explains. Existing investors, first in line, are more receptive if the prior fund has made cash distributions. General partners make their money from a 20% carried interest received either after limited partners get their money back or when investment gains are realised. Management fees, which range from 1.5%-2.5% of committed capital depending on fund size, merely cover overhead. “Private equity guys do not get paid until they sell,” says Justin Wender, senior managing director and

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chief investment officer of Castle Harlan, Inc. “They are than risk additional capital to take the company forward. selling their good properties and they are figuring out how “You probably would not jeopardise a gain. You are going to sell the business,”he says. to improve the ones that are not performing as well.” Sceptics include Sheryl In contrast, public Schwartz, managing director companies hold on to winners and sell losers, No-one wants to bet the farm on private of alternative investments at which often end up in equity, but some new players have so much TIAA-CREF. “If they can demonstrate a compelling private equity portfolios. money that their allocations may test opportunity, then okay, but “When management has capacity. not if it is just a sale from one ownership they really of our funds to another at a change their behaviour very high price,” she says. enormously,” says Christian Oberbeck, a managing partner at Saratoga Partners, “It is TIAA-CREF’s $4bn portfolio includes 140 funds managed not that they were not doing a professional job before, but by 75 firms; annual commitments to private equity funds their incentives are changed. As owners they have a lot to amount to $600m-$800m, plus another $100m-$200m in say about where and how the money gets spent. They start co-investments (money pledged to specific deals alongside to look at their costs in a much sharper manner than they fund investments on the same terms). “The key to this asset class is picking the right partners,” had before.” Distressed credits offer fertile ground for buyout funds, she says, “Doing that right is more important than too. Most corporate buyers worry about potential liability anything.” When TIAA-CREF started investing in 1997, and find bankruptcy reorganisations too time-consuming. private equity was a part time function for people who held “There were a whole lot of companies in bankruptcy two other jobs.“In 1998, we realised this was adverse selection,” years ago; there are very few today,” says Oberbeck, “The Schwartz explains, “We need to be proactive, going out, speed with which our system was able to restructure a lot finding out who the best groups are and calling on them.” of problem companies and credits was largely through the The staff turned full time and results improved; TIAACREF has not reinvested in 20 funds from the earlier period vibrancy of private equity.” Traditional exit strategies for private equity funds that delivered mediocre returns. Aggregate performance figures obscure a sharp divide in evaporated during the bear market. Corporate buyers fled, the high-yield debt market backed away from the private equity market. “There continues to be a very leveraged loans and initial public offerings vanished. wide dispersion in investment returns between the upper Buyout funds sold more companies to each other as a quartile managers, whether they’re buyout or venture, and result. “The last couple of years, they have been playing everyone else,” Sacks says. Some top tier firms find their the musical chair game more and more,” says Aboutar, offerings oversubscribed even when they demand carried “Some investors are finding themselves on both sides of interests up to 30%. “There has been a flight to quality in this market,”says the transaction, and limited partners generally believe that they are better off economically as sellers rather Aboutar, “It is typically the more established players, or firms that have been lifted out of the established players, than purchasers.” Buyout groups defend the practice.“There are a couple that are receiving all the limited partner money.” The of fallacious assumptions that underlie the suspicion,” “venture capital overhang” of excess capital raised in says Wender,“The first is that all financial buyers are the 2000 has become a “limited partner overhang” of same. Different private equity groups bring different investors keen to subscribe to top-performing funds. strengths to the businesses they buy.” A firm that has Managers have taken note, resisting pressure to lower achieved its initial objectives may also prefer to sell rather premium carried interests.

Table 2: Venture-Backed M&A by Year and Quarter, 1999-2004

1999 2000 2001 2002 2003 YTD2004

Total Number of Deals 240 316 350 315 290 247

Disclosed Value Deals 162 202 165 150 123 135

Total Disclosed Transaction Value ($M) 37,545 68,353 17,660 7,830 7,726 12,338

Avg. Size of Disclosed Value Deals ($M) 231 338 107 52 62 91

Source: Thomson Venture Economics & National Venture Capital Association

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During the downturn, limited partners tried to grab a bigger piece of the pie. They went after transaction fees for completing deals and the annual consulting fees some private equity firms charge portfolio companies. “We’re seeing a greater sharing of transaction fees with the limited partners than before,” says Steven Millner, managing director of fund administrator BISYS Private Equity Services, “Where it may have been the general partner retained 80% and the limited partners 20%, we’ve seen it go to 50/50, or even 80/20 in favor of limited partners.” Schwartz thinks the trend has gone farther.“It would be unusual not to be 80/20 (in favour of limited partners) in today's market,”she says, a split she expects to cover all fees. Limited partners failed to dent either management fees or carried interests.“The basic economic model, call it 2% (management) and 20% (carry), has largely stayed intact,” Millner says. Investors will tolerate higher management fees on small funds but expect lower fees on funds over $1bn.“It costs money to put people on airplanes, to go to board meetings, to look at prospective companies, and to keep the lights on at their office,” Metzger notes, but limited partners don’t want general partners to get rich off management fees alone.

Investors have also tightened claw-back provisions. Early funds did not allow the general partner to collect a carried interest until limited partners had received all their money back. In the 1990s, funds adopted deal by deal allocation with a claw-back from the general partner at the end if necessary. “Historically, people didn’t really worry about claw-backs,” says McCormack, “The thought was, it probably wouldn't happen. But there were a lot of cases, I guess because of the telecom bust or the Internet, that claw-backs became real.” Limited partners want general partners to offset losses before they take distributions based on realised gains. “We’re starting to see a shift,”says Millner,“Either towards giving the limited partners all their money back first, or having the claw-back more frequently. If the general partner had a great deal on the first pass, and then had a dog on the second pass, the general partner has to reimburse the limited partners much sooner, not wait until the end of the fund.” As the industry matures, moves are afoot to reduce inconsistencies in documentation. Blaydon is working with funds and law firms to draft standardised terms and conditions for key clauses. “We’re not saying what the

Justin Wender, senior managing director and chief investment officer of Castle Harlan, Inc.

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Table 3: Private Equity Fund-Raising by Year and Quarter, 2000-2004

Year/Quarter 2000 2001 2002 2003 YTD2004 3Q’03 4Q’03 1Q’04 2Q’04 3Q’04

Venture Capital Number of Funds Venture Capital ($M) 635 106,027 305 38,063 164 3,660 134 10,528 125 11,249 31 1,990 54 5,539 46 2,599 51 3,106 46 5,542

Buyout & Mezzanine* Number of Funds Buyout & Mezzanine ($M) 160 76,729 117 44,684 84 26,621 86 29,625 75 32,494 27 5,368 30 15,565 21 2,714 28 15,697 35 14,082

Source: Thomson Venture Economics & National Venture Capital Association * This category includes LBO, Mezzanine, Turnaround and Recapitalization-focused funds.

Public funds that are forced out should find willing carried interest should be, but how the carried interest, distributions and the management fees should be buyers in the secondary market. Funds dedicated to structured so that everybody understands how that secondary investments have already boosted liquidity works,” he says. A common framework will improve and larger portfolios are changing hands.“It used to be if transparency and may bring more efficient pricing to the you wanted to get out it would be a 20% discount (to net secondary market. The group plans to publish its asset value) and now it is at a premium – for a good fund,” says Schwartz. She points out that a premium to recommendations on the Web. An industry accustomed to confidentiality is resisting net asset value (NAV) may still be less than the capital other efforts to lift the veil. In the last 18 months, public invested because the seller has paid management fees. pension plan members have successfully used states’ Buyers may also pay up for funds closed to new investors; freedom of information statutes to obtain data about that secures access to the next round.“If Kleiner Perkins offered us a secondary we private equity investments would jump at the held by their plans, including opportunity,” she says. internal rates of return and After several false starts, the industry details of portfolio company I n s t i t u t i o n a l has finally taken root in Japan. valuations. Some general participation in private “There’s nothing like a large poster-child partners, especially leading equity has put a spotlight like Riverwood to make everybody realise venture capital managers, on interim valuations. that things in Japan really have changed have expelled public plans TIAA-CREF supports an and you can do it,” Blaydon says. Funds from their funds because industry move toward fair they believe disclosure could value accounting but fears are moving into China and India, too, harm their investments. it may allow general according to Aboutar. Start-up companies often partners to accelerate lure employees at belowdistributions. “We market salaries in return for options that will make them encourage it as long as it doesn't lead to premature rich if the company succeeds. When a company falls distributions of carry,” Schwartz says, “We would not behind its business plan, the venture capital firm may have want to see increased claw-back situations.”Accounting to write down its investment. “If that becomes public, rules now require TIAA-CREF to demand financial suddenly you have employee retention issues, you have statements based on US GAAP rather than tax-basis, customers that think you might not be around so they are cost-basis or other methods funds used in the past. In less likely to buy the product,”Wender says,“It can lead to time, investors may be able to check valuations against a serious death spiral.” secondary market prices. Public funds may find it increasingly difficult to participate Institutional money, standardisation and a secondary in top tier private equity funds, and those that do are likely to market all indicate private equity has become mainstream. receive less information than before. “The quest for more “It is a much more accepted type of asset,”says Oberbeck, transparency has really led to less transparency as some of “The irony is that when it was viewed as a risky asset the these general partners have taken strong measures to control returns were very high. Now it is viewed as not risky and it distribution of data to their limited partners,”says Aboutar. has got a lot lower return.”

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DELUGE

In late October the US Securities and Exchange Commission (SEC) voted three to two in favour of hedge fund registration. SEC chairman William Donaldson had pushed hard for registration, arguing that as less well to do investors increasingly put their money into hedge funds, not enough is known about them. Even so, money has continued to flood into hedge funds during 2004, sometimes from surprising sources. By some estimates, industry assets now exceed $1trn. Neil Oâ&#x20AC;&#x2122;Hara assesses the impact of tighter regulation and the general outlook for an industry that has promised much and yet this year, at least, has delivered only a lacklustre performance.

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HE NUMBER OF hedge fund start-ups continues to grow dramatically,” says James Hedges, founder, president and chief investment officer of LJH Global Investments, an advisory firm that helps clients select and invest in hedge funds, “The demand for hedge funds is unabated, the number of hedge fund managers bringing in substantial assets is unbelievable.” Hedges notes that investors are gravitating to “megafunds”that manage $500m or more.“It is creating a very barbelled industry. Some 90% of the industry’s assets are clustered around 10% of the number of funds out there, and the remaining 90% of funds hold 10%,” he says. As a consequence smaller players face immense pressure to escape the competitive disadvantage of subscale operations. Funds of hedge funds account for an increasing proportion of new money flows.“I estimate that 80% of funds coming into hedge funds go through funds of funds today, up from 50% two years ago,” says Hedges, “They are the conduit of choice because they have the capability to do professional due diligence and ongoing monitoring.You get diversification across strategy, across managers, you get risk mitigation.You make it somebody else’s problem.” Even so, outsourcing of fiduciary responsibilities comes at a steep price.“The funds of funds business is going to be plagued by its mediocrity,” he says, “Most of them have terrible performance. It is all going to get out there at some point. It is two or three years out.” “A typical fund of funds, if it is trying to hedge its bets all over the place and be totally diversified, becomes closer to an index fund,” expands Michael Tannenbaum, president of the Hedge Fund Association in New York. “The value added by the manager in picking the subfunds diminishes.” Funds of funds levy management fees up to 1% and performance fees up to 10% on top of the underlying funds’ 1%-1.5% management fees and 20% performance fees. “Some of the funds of funds are reasonable, some aren’t,”he says,“A number don’t charge performance fees, or charge performance fees that are very modest, or that are modest and in excess of a benchmark.” As assets under management balloon, spreads have shrivelled for some popular strategies, such as merger and convertible arbitrage. Although merger activity has picked up, total transaction volume remains far short of the peak reached in 2000. Convertible bond issuance has not kept pace with hedge funds’ asset growth, either. “The market becomes more efficient as the amount of money and the number of players increases,”notes Tannenbaum. The search for higher returns is leading hedge funds into commodities, exotic securities and even private equity, which increases the risk.“Illiquid investments are inconsistent with a strict hedge fund model,” Tannenbaum explains. “Hedge funds typically are open-ended products. Private equity or venture capital investments are illiquid. As a result there are valuation problems.” Hedge funds segregate private equity deals into “side pockets” that lock in participating investors until the underlying investment liquefies, fixing the value.

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Government agencies in Washington are split over the merits of hedge funds. The Federal Reserve, the central bank of the United States (US), more commonly known as the Fed, and the Treasury Department relish the liquidity they provide. On the other side, the Securities and Exchange Commission (SEC) looks at them askance.“I sat down with Alan Greenspan and with (Treasury) Secretary Snow and his staff, and they are just so delighted that hedge funds are there in the illiquid markets,” says John Gaines, president of the Managed Funds Association (MFA), “Then you go to the SEC and they say we have valuation problems. It is like you have crossed a border.” Valuation difficulties extend to over-the-counter swaps, derivatives and other securities for which no ready market exists.“There is no such thing as an independent valuation service,” scoffs Hedges at LJH, who believes the lack of valuation standards is the biggest threat to the hedge fund industry, “The administrators cannot do it; they do not understand the instruments.” In the absence of a market price, managers follow procedures described in their partnership agreements – which they drafted. “It is quite

Michael Tannenbaum, president of the Hedge Fund Association in New York

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arbitrary,”he says,“Hedge fund managers are the ones that decide or define valuation – not a market maker, not a broker dealer, not an auditor, not an administrator.” In its 2003 report Sound Practices for Hedge Fund Managers, the MFA recommends a fair value approach but recognises the limitations for illiquid securities.“The value of that money going into our capital market outweighs the difficulties that are associated with valuation,”says Gaines,“That’s not to say there’s a simple answer to valuation, but it is one of full disclosure and consent by the investor.” Fraud based on bad valuations contributed to the SEC’s decision to force most US hedge fund advisers to register by February 1, 2006. The agency ignored intensive lobbying by the MFA, the US Chamber of Commerce (USCC) and others opposed to regulation. The rule captures advisers who manage more than $30m and have more than 14 US investors in funds with a lock-up period less than two years. Longer lock-ups let private equity and venture capital funds off the hook. Tannenbaum worries the incremental cost may deter John Gaines, president of the Managed Funds Association some younger players, who might otherwise bring new ideas and energy to the industry. He also fears registration is the duplicative and perhaps inconsistent regulation,” says thin end of a regulatory wedge.“I refer to it as the slippery Gaines. Sophisticated investors will have fewer choices if slope problem,”he says,“Okay, we will file the form and we foreign managers forsake the US market. The USCC believes the SEC lacks authority to impose the will adopt the rules, but where does that lead to?” The SEC acknowledges it must “recognise the new rules and has threatened to file suit. In 1985, the SEC important role that hedge funds play in our markets”and defined a “client” under the Investment Advisers Act to denies any intent to dictate hedge fund strategies. Its include a limited partnership but not individual limited assertions convince no one. “Of course there is more to partners because they do not receive independent advice. A come,” says LJH's Hedges. “It is unfortunate the US is letter commenting on the SEC's proposals from Wilmer Cutler Pickering Hale and starting to increase Dorr LLP argued that regulation at a time when Hedge funds may be reluctant to submit to multiple legislative history back to the rest of the world is jurisdictions 1940 supports this starting to liberalise their 180 approach. regulatory regime.” He 160 When Congress believes the new rule is 140 amended the Act in 1970, wasteful and 120 it altered the registration misconceived. “I don’t 100 requirement but not the believe It is going to way advisers count clients. protect the retail investor. 80 “If Congress has met, I don’t believe it is going 60 tinkered with the statute, to protect any investors.” 40 made changes, and not Tannenbaum suggests seen fit to change or that foreign hedge fund FTSE Hedge FTSE All-World override an interpretation, managers, many of whom Data as at 31 October 2004. Source: FTSE Group there’s a presumption that already face regulation in the interpretation is their home country, may be reluctant to submit to multiple jurisdictions. “Maybe correct and has the approval of Congress. Therefore, to there should be some reciprocity,” he says, “I fully change that interpretation requires an Act of Congress,” understand that there’s no reason the SEC should give a Tannenbaum explains, “That is the argument. I do not person registered with the Financial Services Authority in know if it has legs.” Although the MFA has fought hard against registration, London a pass. They could sort that out.” Foreign managers may prefer to evict enough US it has no plans to challenge the rule.“That is history. We lost investors to escape the threshold rather than submit to SEC and we are going forward,” Gaines says,“We look forward scrutiny. “I think some funds will jettison that number of to working with the SEC. If they need to develop US investors to get under 15 so that they can avoid information and knowledge about the hedge fund industry,

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we are in a unique position to provide it to them.” Gains points out that registration brings other rules into play. Registered advisers must adopt a written code of ethics and appoint a chief compliance officer.“It is not just putting a postage stamp on a form and sending it in,”he says. The SEC argues the rule does not impose a significant burden because many hedge fund advisers have already registered. Mindful of their fiduciary responsibilities, most institutions allocate money only to registered hedge fund advisers.“Quite apart from the Commission’s actions, any major player in this business, or any wannabe (sic), would have had to register anyway,” Tannenbaum says, “I think the industry needs to be realistic about that.” As more pension plans invest in hedge funds, the pressure to register increases. Any fund that has more than 25% of its assets from the Employment Retirement Income Security Act (ERISA) plans, which covers a wide range of employee benefit plans, becomes subject to the “plan asset”rule. “The application of the plan asset rule is inconsistent with operating a hedge fund,”Tannenbaum says,“It interferes with performance fees, interferes with soft dollar arrangements.”A hedge fund manager can avoid the plan asset rule by becoming a Qualified Professional Asset Manager if it meets three tests, including $750,000 net worth in the management company and at least $50m under management.“Guess what the third is?” asks Tannenbaum rhetorically.“You have to be registered as an investment adviser.” Hedges distinguishes SEC registration (that he vehemently opposes) from the Treasury’s proposed antimoney laundering rules for investment advisers. “Regulation that protects our national interest so that unregulated vehicles don’t become conduits for people who gained their capital illegally, or use it illegally, that’s a different deal,”he says. MFA members share that view, according to Gaines, because anti-money laundering has a demonstrable benefit. Hedge funds have no desire to shelter money derived from criminal enterprises, political corruption or terrorists. “I didn’t have one member object to what the Treasury proposes to do,” he says, “In fact, they were extremely supportive with their talent and their money and their time to develop guidance to Treasury to get it right.” Tannenbaum hopes the Treasury Department issues final money-laundering rules soon.“The worst thing about rules is not knowing what they are,” he says, “You might have people doing it one way, and then all of a sudden you have another evolutionary scheme out there, and as time goes by they continue to diverge.” He describes the final rules as “regulatory vapourware”. The Treasury published the proposed rules in April 2003. Hedge fund managers won’t have to wait for new rules governing deferred compensation to take effect. Many US-based offshore fund managers defer their share of the performance allocation, which allows them to avoid paying tax until a later date. They did not change the creditor relationship; they just made it harder for the creditors,” Tannenbaum explains, “Offshore rabbi trusts are outlawed by the new rule.”

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

Offshore rabbi trusts are trusts set up in foreign jurisdictions to fund non-qualified deferred compensation programme. Generally speaking a rabbi trust is nothing more than a promise to pay compensation at a later date. Rabbi trusts have commonly been used as top-hat deferred compensation plans for high ranking executives. Under these plans a beneficiary can put stocks, insurance policies or other assets in trust. As a result, a number of hedge fund managers have used offshore rabbi trusts as a means to defer income from current taxation. US regulators have been concerned however that offshore rabbi trusts are set aside often out of reach of a corporation’s creditors – which actually defeats the original purpose of the US Inland Revenue Service allowing them in the first place. Under recent legislation, managers can still defer compensation, but must accept tighter restrictions as well as greater exposure to credit risk – although few managers will have to worry about large deferrals in 2004. For 2005, the MFA has its work cut out to prepare members for registration. “It is education, seminars, compliance guidance; all kinds of things go into the implications of that rule. It is huge,”says Gaines. Will performance rebound? Perhaps – but the deluge of money may make it harder for managers to deliver excess returns.

James Hedges, founder, president and chief investment officer of LJH Global Investments

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PORTFOLIO THEORY 84

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The long-term performance of an all-long, multiple-stock equity portfolio is superior to the average long-term performance of its constituent stocks. This preposterous sounding claim is justified by stochastic portfolio theory, a process that relies on pure mathematical relationships rather than on forecasts of market changes or company earnings and which can be applied to portfolio construction and performance analysis. Relying purely on mathematical dynamics when making investment decisions sounds dubious. But for one investment management firm the process works and it has successfully grown its assets under management over the last three years on the back of it. Dr Adrian D. Banner, INTECHâ&#x20AC;&#x2122;s director of research explains the descriptive mathematical theorem that attempts to capitalise on the random nature of stock price movements.

Putting your

money where your

math is

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COMMON FALLACY is that the arithmetic rate of return of a stock is a good indicator of its longer term performance. This misleading notion is nicely illustrated by a simple example. Suppose that stock XYZ has doubled in price during 2003 but halved in price during 2004. The arithmetic returns for the two years are +100% and -50% respectively, for an annual average return of +25% over the period. On the other hand, the total return on the investment during those two years is actually zero, because the price of XYZ at the end of 2004 is the same as it was at the beginning of 2003. Arithmetic rates of return can not be compounded by taking averages over different periods. Many practitioners and researchers have therefore concluded that a more appropriate measure of long term stock performance is the so-called geometric rate of return, more commonly known as growth rate. Suppose that X(t) represents the value invested in a certain stock at time t and that a time interval beginning at t0 and ending at t1 is fixed. The following equations show how to compute the arithmetic and geometric stock returns for the given time period:

arithmetic return (AR) =

X(t1) – X(t0) X(t0)

geometric return (GR) = log

( )

X(t1) . X(t0)

By the rules for logarithms, the geometric return is also equal to log(X(t1)) – log(X(t0)). Now it is easy to see that geometric returns compound nicely: GRt0→t1 + GRt1→t2 = (log(X(t1)) – log(X(t0))) + (log(X(t2)) – log(X(t1))) = log(X(t2)) – log(X(t0)) = GRt0→t2 This shows that the geometric return over the whole time period from t0 to t2 is equal to the sum of the geometric returns for the two shorter periods. In the case of the stock XYZ the geometric return for 2003 is log(2), since the ratio of the stock price at the end of the year to the beginning of the year is 2. Similarly, the geometric return for 2004 is seen to be log (1/2). The total geometric return for the entire two years is log(2) + log(1/2), which is precisely the correct value – zero. Both in this instance and in general the geometric return rate gives a more accurate picture of the long term stock behaviour.

Relating arithmetic and geometric return rates Now imagine that the time t1 is very soon after t0. If t is equal to t0, then the quantity X(t1) – X(t0), which appears in the numerator of the expression for arithmetic return, may be written as dX(t). In true calculus style, the quantity dX(t) should be thought of as the instantaneous change in X(t) at the precise time t. Similarly, the quantity log(X(t1)) – log(X(t0)) may be cast as dlog(X(t)), the instantaneous change in log(X(t)) at time t. The above equations now take the following form: dX(t) instantaneous arithmetic return at time t = X(t) instantaneous geometric return at time t = dlog(X(t)).

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

It is generally accepted in mathematical finance that the instantaneous arithmetic return satisfies a so-called stochastic differential equation of the following form:

Equation 1 dX(t) = dt + dW(t), X(t) where is the arithmetic rate of return, 2 is the stock variance and W(t) is a Brownian motion. Roughly this equation says that the arithmetic return rate over a short period of time is plus some normally-distributed random piece. Of course, in general the quantities and are allowed to change over time and can even be random themselves. In any case Itô’s rule of stochastic calculus now shows that the corresponding equation for the instantenous geometric return is as follows:

Equation 2 dlog(X(t)) = ( – 12 2) dt + dW(t). The quantity – 12 2 is therefore equal to the geometric return rate, which is denoted by . Another way of stating this fact is that the arithmetic return rate exceeds the geometric growth rate by one half of the variance 2. Therefore: = + 12 2. In the case of the stock XYZ, the annual standard deviation of the stock price is = log(2), which is approximately 0.7. The variance is then approximately given by 2 = 0.5. The annual arithmetic return rate is 0.25%, so = 0.25. The geometric return rate is 0. In this case, (0.25) is indeed (0) plus one half of 2 (0.5). In the continuous-time setting of instantaneous returns as in the above equations, the numbers work out exactly, without any need for approximation. The strong law of large numbers can be used to show that the Brownian motion term dW(t) in Equation 2 above is dominated over the long term by the drift term ( – 21 2 ) dt= dt. It follows that the long-term behaviour of the stock price is indeed governed by the growth rate . Why not then try to apply the same logic to the arithmetic rate of return? The problem arises from the denominator X(t) in Equation 1. Its presence invalidates the use of the strong law.

Portfolio Growth Rate Long-term stock performance is governed by the stock’s geometric return rate. The same holds true for long-term portfolio performance: the geometric return rate of the portfolio is the key quantity in this regard. How does the geometric return rate of the portfolio relate to the geometric

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PORTFOLIO THEORY

return rates of the stocks in the portfolio? You might think that a weighted average works. But it doesn’t. Blindly replacing the arithmetic return rates with their geometric equivalents in Markowitz’s formulas is an error. The reason is straightforward. According to Markowitz’s modern portfolio theory, the rate of return π of a portfolio π with weights given by π1, π2, …, πn (which add up to 1) is given by n = i i

∑ = i 1

where i is the rate of return of the ith stock. That is, the portfolio rate of return is equal to the weighted average stock rate of return. From this point on ‘rate of return’ will always refer to the arithmetic return rate and ‘growth rate’ will refer to the geometric return rate. On the other hand, the growth rate π of the same portfolio π is NOT equal to the weighted average of its component stock growth rates. The true value of the portfolio growth rate is given by the following formula (please see Box 1. The Formula for Portfolio Growth Rate):

Equation 3 =

i i + * ∑ = i 1

where i is the growth rate of the ith stock. This equation says that the portfolio growth rate is equal to the weighted average stock growth rate, PLUS an extra quantity *. π This quantity is called the excess growth rate of the portfolio. The formula for this is:

BOX 1: THE FORMULA FOR PORTFOLIO GROWTH RATE

HE RATE OF return for a stock exceeds the growth rate by one-half the stock variance. The same holds for a portfolio: a portfolio’s rate of return exceeds its growth rate by one half of the portfolio variance. The observation that

portfolio rate of return = weighted average stock rate of return then leads to the following relationship

portfolio growth rate + 21 (portfolio variance) = weighted average stock growth rate + 21 (weighted average stock variance) Subtracting one half the portfolio variance from each side leads to the correct formula for portfolio growth rate. Equations 3 and 4 follow immediately.

Equation 4 * =

1 2

(∑ i=1

i 2i –

)

∑ i j ij

i,j=1

Here, as in modern portfolio theory, 2i denotes the variance of the ith stock and i j denotes the co-variance between stocks i and j. The above formula shows that the excess growth rate is one half the difference between the weighted average stock variance and the classical portfolio variance. All together then equations 3 and 4 provide the following decomposition of the portfolio growth rate: portfolio growth rate = weighted average stock growth rate + 12 (weighted average stock variance – portfolio variance). A pleasant fact is that the excess growth rate must be positive if no short sales are permitted and the portfolio contains more than one stock. Since the portfolio and stock growth rates determine their respective long-term performance, the above equation implies that the longterm portfolio performance exceeds the average longterm stock performance, justifying the claim made at the beginning of this article. The amount of excess is determined by the excess growth rate π*, which depends only on the portfolio weights, stock variances and covariances.

An example How can the growth rate of a portfolio exceed the average stock rate? For simplicity, assume that the underlying market is very simple: there are only two stocks, which are called A and B. Suppose also that these stocks are both very volatile but have a growth rate of 0. Furthermore, suppose that the stocks are perfectly negatively correlated. When one stock doubles in price, the value of the other stock falls by a half. The situation is nicely modelled by repeatedly tossing a coin, insisting that a result of heads means that A doubles in price and B halves in price over a given period of time (and vice versa for a result of tails). Both of the stocks behave in the same manner as stock XYZ. If the coin is tossed many times, it is likely that roughly half of the tosses will have been heads and half will have been tails. Therefore the growth rate of both stocks is indeed 0. Holding just one of these stocks leads to no long term growth. What happens if we hold both stocks? Suppose one invests £100 in each stock. Regardless of the result of the first coin toss, the investment in one of the stocks will return £200 and the other will return £50, for a guaranteed total of £250. This represents a net gain of 25% and is an example of the excess growth rate at work. Among the two stocks, the winner has gained more than the loser has lost. After one coin toss, the portfolio is more concentrated in one of the stocks. This means that the portfolio variance has increased, so the excess growth rate has decreased.

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

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BOX 2: FURTHER READING ON STOCHASTIC PORTFOLIO THEORY

Dr Adrian D. Banner, INTECH’s director of research

This suggests that an investor in this hypothetical twostock market should take steps to lock in his or her gains by rebalancing to equal weights after each coin toss. In this hypothetical market, this strategy leads to a nonvolatile, guaranteed rate of return (and growth rate) of 25% per toss! There is a huge advantage to holding the portfolio as opposed to either one of the stocks by themselves. Of course, in real markets, it is extremely unlikely that two stocks will maintain a perfect negative correlation over a long period of time. The excess growth rate of a realistic portfolio is therefore a lot lower than in the above example, but it is still significant. Indeed, the excess growth rate of the S&P500 index during the 1990s was over 4% per annum.

Implications and applications A startling consequence of this observation is that a capweighted index outperforms its constituent stocks in the long term. How is this possible? Suppose for a moment that the index is never reconstituted. That is, the index constituents never change. What is the eventual fate of this index? As time goes by, more and more unfortunate stocks, which should have left the index, collect at a tiny weight at the bottom of the index. This also means that, gradually, fewer and fewer stocks have a significant weight in the index.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005

tochastic portfolio theory had its genesis in a 1982 paper by E. Robert Fernholz and Brian Shay entitled: Stochastic Portfolio Theory and Stock Market Equilibrium, published by the Journal of Finance #37, pages 615 to 624. Stochastic portfolio theory is a mathematical methodology for constructing stock portfolios, analysing the behaviour of portfolios and understanding the structure of equity markets. The definitive reference of the theory can be found in the 2002 monograph Stochastic Portfolio Theory, by E. Robert Fernholz (Springler-Verlag, New York). The theory has both theoretical and practical applications. It can be used, for example, to construct theoretical portfolios that have specific characteristics. While Robert Fernholz in a 2003 paper entitled “The Application of Stochastic Portfolio Theory to Equity Management,” says that the stochastic methodology; “is particularly appropriate for institutional equity managers whose objective is to outperform a benchmark index under conditions of controlled risk.” Additional developments in the theory can be found in the paper “Diversity and Relative Arbitrage in Equity Markets” by R. Fernholz, I.Karatzas and C. Kardaras that will appear in the specialist journal Finance & Stochastics.

This decline in diversification leads to a fall in the excess growth rate, culminating in the situation where one stock completely dominates the index and the excess growth rate is almost zero. It is only the index reconstitution which prevents this from happening. In other words, individual companies eventually wither, but the index remains strong, outperforming its constituent stocks. How can stochastic portfolio theory apply to portfolio construction? The formula for portfolio growth rate suggests that a portfolio with a higher excess growth rate than that of a benchmark index should outperform that index in the long term, provided that the weighted average stock growth rate does not cause this advantage to dissipate. Data from large-cap United States (US) stock universes are consistent with the hypothesis that stocks in such universes have approximately the same growth rates over any one year period. This hypothesis would seem to indicate that long-term portfolio performance is essentially dependent only on the excess growth rate. Even if fundamental methods are used to select stocks and estimate growth rates, the formulas presented above should be taken into account when performing a portfolio optimisation. If not, portfolio managers may find it difficult to reconcile short-term performance estimates with actual observed long-term performance.

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Page 88

FTSE Global Equity Index Series – Global YTD 2004

31st December 2003 - 29th October 2004

FTSE Regional Indices Performance (USD) 130

FTSE Global AC

120

FTSE Developed Europe AC

110

FTSE Japan AC

100

FTSE Asia Pacific AC ex Japan

FTSE Middle East & Africa AC

FTSE Emerging Europe AC

FTSE Latin America AC

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

FTSE Developed Country Indices Capital Returns

Dollar Value

Local Currency Value

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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FTSE All-Emerging Country Indices Capital Returns 100 80 60 40

Dollar Value 20

Local Currency Value

0 -20

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Stock Performance Best Performing FTSE All-World Index Stocks (USD) Aristocrat Leisure 395.1% Cairn Energy Plc 275.7% Elan Corp 273.1% Hylsamex 262.7% Global Media Online 184.1%

Overall Index Return FTSE Global AC FTSE Global LC FTSE Global MC FTSE Global SC FTSE All-World FTSE Asia Pacific AC ex Japan FTSE Latin America AC FTSE All Emerging Europe AC FTSE Developed Europe AC FTSE Middle East & Africa AC FTSE North Americas AC FTSE Japan AC

Worst Performing FTSE All-World Index Stocks (USD) LG Card -88.2% Natural Park -86.4% Quanta Storage -78.6% Viad Corp -78.5% PSC Industries -77.6%

No. of Consts

Value

YTD

Actual Div Yld

7,326 1,037 1,840 4,449 2,877 1,600 176 83 1,549 174 2,407 1,337

278.81 276.88 355.09 319.33 167.51 305.87 398.29 397.48 290.74 352.15 266.47 287.50

2.4% 2.2% 2.9% 2.4% 2.4% 2.2% 3.1% 5.5% 3.6% 6.5% 1.7% 2.3%

5.1% 4.3% 6.9% 6.5% 4.9% 10.7% 16.1% 20.3% 7.6% 14.8% 3.6% 0.1%

4.6% 2.7% 9.0% 8.6% 4.1% 6.0% 18.8% 24.3% 6.3% 19.7% 2.9% 5.2%

2.03% 2.18% 1.72% 1.63% 2.08% 2.93% 3.64% 2.42% 2.72% 2.79% 1.68% 1.01%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2005

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Page 90

FTSE Global Equity Index Series – Developed ex US YTD 2004

31st December 2003 - 29th October 2004

FTSE Developed Regional Indices Performance (USD) 115

FTSE Developed (LC/MC)

110

FTSE Developed Europe (LC/MC)

105

FTSE Developed Asia Pacific (LC/MC)

100

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FTSE Developed Regional Indices Capital Returns (USD) 16

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Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD) Aristocrat Leisure 395.1% Nishi-Nippon City Bank 150.2% Tower Limited 97.6% Caltex Australia 91.6% ComfortDelgro Corp 78.9%

Overall Index Return FTSE Developed ex US (LC/MC) FTSE USA (LC/MC) FTSE Developed (LC/MC) FTSE All-Emerging (LC/MC) FTSE Developed Europe (LC/MC) FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed AC ex US (LC/MC) FTSE Developed LC ex US FTSE Developed MC ex US FTSE Developed SC ex US

Worst Performing FTSE Developed ex US Index Stocks (USD) Converium Holding AG -72.3% Interchina Holdings -68.5% Seibu Railway -65.2% Seat-Pagine Gialle -64.5% Brilliance China Automative Holdings -62.0%

No. of Consts

Value

YTD

Actual Div Yld

1,361 633 1,994 883 513 777 297 3,599 509 1,840 4,449

177.09 461.82 165.35 229.23 176.69 165.70 261.50 295.63 281.66 329.52 349.02

3.5% 1.4% 2.4% 2.5% 3.6% 2.8% 3.5% 3.5% 3.5% 3.5% 3.2%

6.7% 2.7% 4.5% 12.6% 7.5% 3.4% 11.4% 6.7% 6.4% 7.7% 7.3%

6.3% 1.8% 3.8% 8.5% 5.5% 6.2% 11.5% 7.0% 5.2% 10.7% 14.2%

2.40% 1.73% 2.04% 2.80% 2.76% 1.69% 3.26% 2.36% 2.47% 1.72% 1.63%

FTSE Global Equity Index Series – Asia Pacific YTD 2004 31st December 2003 - 29th October 2004

FTSE Asia Pacific Regional Indices Performance (USD) 120

FTSE Global AC

115

FTSE Developed Asia Pacific (LC/MC)

110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105 100

FTSE Asia Pacific (LC/MC)

95 90

FTSE All-Emerging Asia Pacific AC

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Capital 0

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O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rs e & Me r En Ele ified D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs P o & on du Te arts a ce Ph l Ca rs Be xtil ar re e v & e s m & Pr rag ac H oc e eu o es s tic use so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su e o & re tai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt v m & m Dr Tra ice un u ns s ica g R po tio et rt n aile Se rs r Ut El vic ilit ec es ie tric s - O ity th In B er ve L In an st ife su ks In m A ra fo S en s nc rm pe t C su e a cia om ran So tion lity c ftw T & Re pan e ar ech Ot al ies e no he Es & r t Co logy Fin ate m H an pu ar c te dw e rS a er re vi ce s

-20

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD) Aristocrat Leisure 395.1% Nishi-Nippon City Bank 150.2% Hynix Semiconductor 141.4% LG Corp 136.2% SK Corporation (Yukong ) 127.2%

Worst Performing FTSE Asia Pacific Index Stocks (USD) LG Card -88.2% Quanta Storage -78.6% PSC Industries -77.6% Interchina Holdings -68.5% Seibu Railway -65.2%

Overall Index Return FTSE Global AC FTSE Asia Pacific AC Index FTSE Asia Pacific (LC/MC) FTSE Asia Pacific LC FTSE Asia Pacific MC FTSE Asia Pacific SC FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia-Pacific FTSE Japan Index (LC/MC)

No. of Consts

Value

YTD

Actual Div Yld

7326 2937 1348 478 870 1589 297 777 571 480

278.81 294.96 167.63 284.73 321.12 330.17 261.50 165.70 176.68 107.40

2.37% 2.29% 2.35% 2.44% 1.99% 1.66% 3.53% 2.76% 0.79% 2.41%

5.10% 4.51% 4.65% 4.61% 4.79% 3.15% 11.44% 3.39% 9.87% 0.14%

4.57% 5.66% 5.16% 4.86% 6.37% 10.49% 11.52% 6.22% 0.93% 3.96%

2.03% 1.85% 1.86% 1.90% 1.70% 1.78% 3.26% 1.69% 2.55% 0.99%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

JANUARY/FEBRUARY 2005 â&#x20AC;˘ FTSE GLOBAL MARKETS

ct io

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FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2005 AC

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FTSE Global Equity Index Series – Europe YTD 2004

31st December 2003 - 29th October 2004

FTSE European Regional Indices Performance (EUR) 115

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

105

FTSEurofirst 300 (EUR)

100

FTSE Developed Europe AC (EUR)

FTSEurofirst 100 (EUR)

FTSE Eurozone LC/MC (EUR)

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

FTSE Developed Europe Sector Indices Capital Returns (EUR)

Capital

Total Return

-10

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR) Verbund Oesterreich Elektrizitats 65.9% Ericsson B 60.2% Reuters Group 60.1% Nobel Biocare Holding 59.6% OMV 59.4%

Worst Performing FTSE Developed Europe Index Stocks (EUR) Converium Holding AG -72.5% Seat-Pagine Gialle -64.8% Karstadtquelle -54.6% Cap Gemini -44.0% Terra Networks -41.0%

Overall Index Return No. of Consts

Value

YTD

Actual Div Yld

7326 1632 210 359 1063 1549 83 752 1045 300 80 100

278.81 264.28 300.00 309.27 311.56 263.18 359.8 271.69 271.76 998.13 3517.89 3355.11

2.37% 1.14% 1.16% 1.08% 0.69% 1.11% 3.02% 2.50% 1.75% 1.14% 2.83% 1.18%

5.10% 2.01% 1.54% 2.63% 2.76% 1.85% 13.89% 3.56% 2.92% 1.64% 3.29% 1.42%

4.57% 5.61% 3.53% 9.65% 12.24% 5.36% 23.24% 4.77% 5.19% 4.20% 2.26% 2.11%

2.03% 2.72% 2.80% 2.55% 2.40% 2.72% 2.42% 2.64% 2.48% 2.78% 2.80% 2.99%

FTSE Global AC FTSE Europe AC FTSE Europe LC FTSE Europe MC FTSE Europe SC FTSE Developed Europe AC FTSE All-Emerging Europe AC FTSE Eurozone AC FTSE Developed Europe ex UK AC FTSEurofirst 300 FTSEurofirst 80 FTSEurofirst 100

FTSE UK Index Series – YTD 2004 31st December 2003 - 29th October 2004

FTSE UK Index Series Performance (GBP) 130

FTSE 100

125

FTSE 250

120

FTSE 350

115 110

FTSE SmallCap

105

FTSE All-Share

100 95

FTSE AIM

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JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

F T S -6% E GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2005

Chemicals

Aerospace & Defence

Diversified Industrials

Electronic & Electrical Equipment

rospace & Defence

versified Industrials

ctronic & Electrical Equipment

Food Producers & Processors

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

Capital

Health

Total Return

Leisure & Hotels

General Retailers

-20

-30

Stock Performance

Worst Performing FTSE All-Share Index Stocks (GBP) Jarvis -81.2% Courts -76.4% Wolfson Microelect -69.2% Ultraframe -63.3% Filtronic -63.3%

Overall Index Return 1M 3M YTD Actual Div Yld Net Cover P/E Ratio

100 250 350 344 694 378 902 100 4624.21 6321.79 2339.68 2601.11 2297.66 2940.41 963.93 1136.47 1.2% 0.8% 1.1% 1.8% 1.1% 3.2% 4.9% 5.0% 4.8% 5.0% 4.8% 4.9% 4.8% 6.2% 11.4% 6.9% 3.3% 9.0% 4.1% 5.1% 4.1% 12.1% 15.4% 12.0% 3.23% 2.78% 3.17% 2.27% 3.13% 2.46% 0.52% 1.39% 2.16 1.98 2.14 -0.01 2.09 -1.95 -0.36 14.34 18.2 14.77 0 15.29 0 0 -

Utilities - Other

Total Return

Utilities - Other

-10

Electricity

Capital

Electricity

Telecommunication Services

elecommunication Services

Food & Drug Retailers

od & Drug Retailers

Transport

FTSE All-Share Sector Indices Capital Returns (GBP)

Transport

Value

Support Services

No. of Consts

Support Services

ia & Entertainment Media & Entertainment

Leisure & Hotels

General Retailers

Tobacco

Pharmaceuticals & Biotechnology

al Care & Household Personal Care & Household Products Products

Health

Food Producers & Processors

0% 4%

Beverages

Jamie Perrett -2% Senior 2% Index Design Executive jamie.perrett@ftse.com -4% +440% 20 7448 1817 337.1% 267.1% 142.5% 89.3% 78.3%

Beverages

Gareth Parker 8% Head4%of Index Design gareth.parker@ftse.com 6% 2% +44 20 7448 1805

Household Goods & Textiles

Carl Beckley Director, Research & Development carl.beckley@ftse.com 8% +44 20 7448 1820

ousehold Goods & Textiles

FTSE 100 FTSE 250 FTSE 350 FTSE SmallCap FTSE All-Share FTSE Fledgling FTSE AIM FTSE techMARK 100

Automobiles & Parts

Best Performing FTSE All-Share Index Stocks (GBP) Ashtead Group Cairn Energy Charter Paladin Resources Dana Petroleum

utomobiles & Parts

12:49 pm

eering & MachineryEngineering & Machinery

Steel & Other Metals

Forestry & Paper

teel & Other Metals

Forestry & Paper

struction & Building Construction & Building Materials Materials

Chemicals

Mining

Oil & Gas

-4%

Oil & Gas

Mining

-2%

8/12/04

MARKET REPORTS BY FTSE RESEARCH

M O inin il & g C ild h Ga in em s F g El St ore M ica ec e e s at ls tr on Ae l & try eria ic ro O & ls & sp th Pa E En le ace er M per gi ctr & e ne ic D ta e r a l ef ls Ho in E e us Au g & qui nce pm eh to ol mo Ma en d c Fo Go bile hin t od s e o Pe d s & ry Pr rs & Pa od on Te rts uc al e r B xt Ph Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho H rs s l & d ea P Bi r lth ot od ec uc hn ts Ge o ne To log M L ra b a y ed ei l R c s ia u et co & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le ood er nt co v m & m Dr Tra ices u n u ns g p ic at Re or io ta t n ile Se rs rv U t El ice ili ec s tie tr s icit -O y th e B r In ve L Ins ank st ife ur s In m A a en ss nc fo Sp rm e t C ur e at cia om an So ion lity p ce ftw T & Re an ar ech Ot al E ies e n o he s & lo r ta Co gy Fin te m H an p u ar ce te dw rS a er re vi ce s n

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MARKET REPORTS.QXD

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FTSE Research Team contact details

Bin Wu Senior Index Design Executive bin.wu@ftse.com +44 20 7448 8986

Oliver Whittle Index Analyst oliver.whittle@ftse.com +44 20 7448 1887

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7448 8013

-6%

MARKET REPORTS.QXD

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CALENDAR

Index Reviews January-March 2005 Date

Index Series

Review Type

Effective (Close of business)

Data Cut-off

Early Jan

S&P / TSX Composite

Quarterly review

14 Jan

Jan

AEX

Annual review

1 Mar

31 Dec

Mid Jan

HEX 25

Semi-annual review

28 Jan

31 Dec

8 Jan

TSEC Taiwan

Quarterly review

21 Jan

31 Dec

11 Jan

FTSE Xinhua

Quarterly review

21-Jan

17-Dec

21 Jan

AEX

Quarterly review stock classification

3 Feb

26 Jan

HEX 25

Quarterly review of number of shares

28 Jan

Jan/Feb

CAC 40

Quarterly review

Feb/Mar

Jan/Feb

BEL 20

Annual review

1 Mar

End Jan/Feb

Hang Seng

Quarterly review

27 Feb

Early Feb

DAX 30

Quarterly share / FF adjustment

16 Mar

12 Feb

MSCI

Quarterly review

27 Feb

17 Feb

STOXX

Quarterly review (components)

18 Mar

28 Jan

Early Mar

MIB 30

Semi-annual review

21 Mar (1)

28 Feb

Early Mar

ATX

Semi-annual review / number of shares

31 Mar

28 Feb

1 Mar

FTSE Gold Mines

Quarterly review

18-Mar

–

1 Mar

SMI

Semi-annual rebalance

31 Mar

28 Feb

5 Mar

S&P/ASX 200

Annual /Quarterly review

18 Mar

28 Feb

8 Mar

FTSE4Good

Semi annual review

18-Mar

28-Feb

9 Mar

FTSE Euromid

Quarterly review

18-Mar

4-Mar

9 Mar

FTSE Euro 100

Quarterly review

18-Mar

4-Mar

9 Mar

FTSE/JSE

Quarterly review

18-Mar

4-Mar

9 Mar

FTSE techMARK

Quarterly review

18-Mar

28-Feb

9 Mar

FTSE UK

Quarterly review

18 Mar

8 Mar

12 Mar

NZSX

Quarterly review

31 Mar

12 Mar

FTSE All-World

Annual review Asia Pacific ex Japan

18 Mar

31 Dec

12 Mar

FTSEurofirst 300

Quarterly review

18 Mar

4 Mar

12 Mar

FTSE/Hang Seng Asiatop

Semi-annual review

18 Mar

28 Feb

14 Mar

NASDAQ 100

Quarterly share adjustment

18 Mar

14 Mar

FTSE eTX

Quarterly review

18 Mar

16 Mar

STOXX

Quarterly share adjustment

18 Mar

16 Mar

S&P 500

Quarterly share adjustment

18 Mar

17 Mar

16 Mar

S&P / TSX 60

Quarterly share adjustment

18 Mar

17 Mar

16 Mar

S&P MidCap 400

Quarterly share adjustment

18 Mar

17 Mar

31 Dec

28 Jan

4 Mar

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

JANUARY/FEBRUARY 2005 • FTSE GLOBAL MARKETS

MARKET REPORTS.QXD

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12:50 pm

Page 97

The children of Darfur in Sudan are caught up in a horrific conflict which is having a devastating effect on their lives.

UNICEF/ HQ04-0292/Christine Nesbitt

Over 1 million people have fled their homes and entire villages have been destroyed and hundreds of lives have been lost. Children’s lives are at great risk of disease and malnutrition. Water and shelter are in short supply. Right now, children are depending on UNICEF to stay alive. To find out more about how you and your company can help UNICEF when an emergency occurs, please contact victorial@unicef.org.uk or visit: www.unicef.org.uk/emergencyrelief if you are in the UK or www.supportunicef.org if you´re outside of the UK Thank you for your support

With a presence in over 190 countries, UNICEF (the United Nations Children’s Fund) is uniquely positioned to react quickly to emergency situations such as the one in Sudan. We have been working tirelessly since the emergency began, providing medical supplies and access to safe water and sanitation. To carry out our emergency work, we desperately need the help of individuals and companies. FTSE already support UNICEF (over £900,000 donated through FTSE4Good so far). In doing so, they help us to alleviate the distress and hardship caused to children who find themselves suffering because of emergency situations like the one in Darfur.

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Page 98

RULE #9 IT PAYS TO USE THE RIGHT TOOLS FOR THE JOB

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